What Next for Bitcoin?

The investment landscape for Bitcoin has recently experienced notable developments, particularly with the U.S. approval of various Bitcoin Exchange Traded Funds (ETFs). This has significantly increased demand and price, enabling retail investors to bypass the complexities of blockchain technology and regulatory hurdles, facilitating easy ownership of this leading cryptocurrency.

I have long argued that cryptocurrency is an important inclusion in investment portfolios , with research showing that these can enhance returns and reduce volatility. And, if you focus on the macro trends, this should be no surprise.? Increasing access to technology (especially in countries with low banking penetration), inflationary monetary policy from many governments and a post-Covid sensitivity to the fragility of social cohesion all play to the strengths of cryptocurrency as a store of value.

And there is nothing wrong with (in particular) Bitcoin being treated as an electronic store of value in this context.? It is secure, liquid, low-cost to access and hold, and increasingly well-understood and treated by regulators.? But it is worth remembering that this store of value is secondary to the main reason for its invention - as a medium of exchange in daily transactions.

In 2009, the world was starting its recovery from the Global Financial Crisis (oh happy days…) and (still pseudonymous ) Satoshi Nakamoto released the seminal whitepaper “Bitcoin: A Peer-to-peer Electronic Cash System ”.? In it, s/he explains “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party”(my emphasis).

In other words, Bitcoin was invented primarily to serve as an electronic medium of exchange, solving the double-spend problem as well as replacing the authority of federal governments with cryptography.? Yet, right now this purpose has been supplanted by Bitcoin being used as both a store of value and its derivative, a trading tool by speculators.

It is possible for Bitcoin to ‘evolve back’ to its intended use.? I believe that one day, consumers will have the ability, should they choose, to conduct their everyday business in the same way they use credit cards and fiat currency presently (and I am happy to invoice my clients in Bitcoin!)

But this day is still some distance away.? Several steps need to occur for this to become a reality.? Ironically, these will have the possibly contradictory benefit of increasing the value of Bitcoin.? But all of these will provide many benefits for the world’s population and act as an incredible economic stimulus.

Consumer Ecosystem?

First up, the User experience (UX) to use Bitcoin is just hard. To buy Bitcoin, you need to open an account with a Crytoexchange, satisfy KYC/AML then work out how to transfer fiat into the account and place an order.? And, even then, the exchange will most likely lean on you to keep the BTC within your account, where its external usage is very limited.? Try and transfer it out to your wallet (establishing which is itself another not insignificant process of choosing a method, provider, and saving passwords) and you’ll most likely be subject to further interrogation by the exchange who hate to see your assets leave their clutches.??

And that’s just getting ready to be able to spend it!? The benefit of a peer-to-peer system is that there is no ‘middle-man’ but equally, that means you need to be careful that you are sending your Bitcoin to the right address.? There are some early retail systems to make this easy, but they involve (as do most Bitcoin transactions) scanning? QR codes to ensure the recipient address is copied correctly.? Still a long way from Tap and Go, or handing over some cash, that most people use right now.

Which leads to a related problem for mass consumer adoption of Bitcoin:

Speed

If Bitcoin is competing against current payment platforms, the immediate question is, can it compete on price and volumes?? And, right now, the answer is “No”.? The Bitcoin blockchain can handle about 7 transactions per second , compared to Mastercard at 5,000 per second and Visa at up to 24,000 per second .? All that adds up to a lot of standing around for customers, potentially up to an hour for the final transaction to be verified on the blockchain.? This is where Bitcoin’s strength becomes its weakness, as the lack of a central authority means time and computing power to verify and secure - but at the same time making the price for average retail transactions uncompetitive .

There is some good news on the horizon - the development of ‘Layer 2’ networks built on top of the Bitcoin blockchain.? These mini-networks make some short-term technical compromises on security and decentralisation to increase speed and reduce costs.? The Lightning Network is the most prominent example and holds real promise through establishing channels, separate from the blockchain, between Bitcoin users.? These transactions are then grouped and posted, in summary form to the main blockchain together once all transactions between the parties are complete.? The result:? much faster and cheaper processing times.

Price Stability

Bitcoin still lacks one of the most important properties to become a good store of value: price stability. ? Ironically, Bitcoin's success as a speculative investment may retard its ability to act as a medium of exchange.??

After all, why buy your groceries with Bitcoin if you are confident that it will be worth more next week? Why accept Bitcoin as payment if your business has to pay tax in fiat and you aren’t confident it won’t be worth less when it is tax return time?? More than the absolute value of its value, it is the volatility of Bitcoin that also contractions its use as money right now.??

But where does this volatility come from, and how can it be managed?? If price stability is a result of demand being stable relative to its supply, then clearly, in the case of Bitcoin which has a fixed rate of supply, it is the wildly fluctuating demand that has created the volatility.? In other words, for Bitcoin to be used as money, the demand for it needs to be stabilised.

One approach is to adopt the same sort of solutions that fiat currency has used:? create and adopt financial derivatives and credit which is backed by Bitcoin (rather than using Bitcoin itself).? If Layer 2 solutions like the Lightning Network can increase the velocity of Bitcoin, credit? - or even cash money backed by Bitcoin (rather than your federal bank) - could increase the demand and hence bring in price stability.

The Future is Bright if yet to be Created

I was listening to a recent podcast with physicist Stephen Wolfram where he observed that predicting the future of what technological developments will bring was much simpler than guessing when they might happen:? the former is relatively straightforward, but with the latter, it’s easy to be even decades off the mark.

Similarly, I believe that it will be an inevitable consequence of many factors (technological, societal and political amongst them), will see Bitcoin eventually adopted as a quotidian medium of exchange, used by people around the world.? As I have argued, there is still a lot that has to happen for this to occur. But these changes are being discussed and worked on? - and may happen far quicker than we anticipate.??

The exciting part is that we can be part of this change.? Until then, Bitcoin (and other cryptocurrencies) should not be excluded as part of an investment portfolio, and the underlying promise of blockchain to transform our economy be considered as part of your investment decisions.?