What Gives Bitcoin Its Value?

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Bitcoin - Economists and journalists often get caught up in this question: Why does Bitcoin have value? And the answer is very easy. Because it is useful and scarce.
—Eric Voorhees, cofounder of the Bitcoin company Coinapult
Many people wonder what gives Bitcoin its value. The first question many people ask is whether Bitcoin is backed by anything. The answer: Bitcoin is backed by its code as well as its utility—that is, what it can do. If Bitcoin stops being useful, it will lose its value.

People will often argue that Bitcoin’s value comes from what people think it is worth. This statement can be made about anything, yet it is not quite accurate. You may be willing to pay a dollar for a bottle of Aquafina, or two dollars, depending on what you perceive that bottle of water to be worth. So yes, our perception of a thing’s value does have a direct effect on that value. But if Aquafina started putting out water that was unfiltered and partially filled with mud, it would be less refreshing and people would not be willing to pay as much because it wouldn’t be as useful.

The utility of Bitcoin is the foundation on which everything else is built. Without this utility, everything else falls apart. All the speculative day trading is just noise. Its scarcity is a big factor but ultimately that also goes back to utility. Bitcoin has a hard cap on the number of coins that will be created. There will only ever be 21 million bitcoins in existence. 

New bitcoins are created when miners solve a new block and are rewarded for their trouble through a combination of new coins and the miner fee. (You “solve a new block” when your computer—or more often, dedicated mining software—figures out the complex mathematical problems that confirm the accounts sending bitcoins have the bitcoins to send and have digitally signed their transactions.

Each block currently has 750KB to 1MB worth of transactions.) Roughly every four years, the number of new coins created per block will be cut in half, until 21 million are eventually created—and at that point, miners will have to sustain themselves entirely on fees. This is forecast to occur sometime in the next century. Knowing the parameters of Bitcoin in advance makes Bitcoin more useful as a speculative investment and as a currency.

When proponents of the gold standard make their pitch, they often point out that gold has utility. A dollar is simply a piece of paper. Gold, they argue, holds real value as a commodity, as a valuable mineral for electronics, and—as it has been for thousands of years—as an attractive material for jewellery. Yet even a commodity-backed currency is dependent on the word of the issuing body.

Although gold and other precious materials will likely always hold some value, if every government office shuts down, a piece of paper that says it is worth an ounce of gold is still just a piece of paper. If you are living in the United States, the thought of the government disappearing overnight might not seem like a realistic fear, but for citizens of third world countries, or even traditional first world countries with economic problems, such as Greece, that fear is a bit more palpable.

Bitcoin gets its value from what it can accomplish without any issuing body. This is different from saying that is where it gets its price. Bitcoin’s price is influenced by a lot of things: adoption, speculation, and value all make up major pieces of the equation. But its actual value comes from its utility. In a theoretical world where speculation doesn’t affect the price of Bitcoin, the price of one bitcoin would be whatever it is because of its value and scarcity, and that value is made up entirely of its utility. Furthermore, without that value, everything else would collapse like a house of cards.

What that utility is, is still being developed. Bitcoin already has many uses and I will cover them in a later chapter, but let me briefly run through some of the more obvious ones. First, Bitcoin can be sent anywhere in the world for an extremely small fee—generally around $0.02—opening up huge opportunities for remittance.

Bitcoin and other technologies based on blockchains are also programmable, giving them utilities that haven’t even been thought of yet. For example, people have been able to use Bitcoin to invest in securities, stocks, valuable materials, and even other currencies from around the world, without the fees and high cost of entry typical of traditional methods for investment in those areas.

For the economically paranoid, Bitcoin also offers a store of value outside the direct influence of governmental organizations as well as offering the possibility of anonymity for embarrassing or illegal services.

From a merchant perspective, Bitcoin also has the advantage of not having large fees from credit card companies that cut into their profits. Credit card companies typically charge between three to four percent for each transaction, a fee the merchant normally takes on themselves. For merchants with small profit margins, that fee could eat up half or more of their profits for each credit or debit card transaction. As noted earlier, Bitcoin, by contrast, has a miner fee of around $0.02 and could therefore greatly increase merchants’ profit margins.

Early in the life of the Internet, many pioneers envisioned an economy run entirely online. In the early 1990s, author Bill Eager was writing books about marketing on the Internet before marketing on the Internet was something most companies spent much time thinking about. At the time, buying something online, particularly physical goods, wasn’t just rare. For most items, it was impossible.

In 1994, Eager made a striking prediction. In his book The Information Superhighway Illustrated, he wrote, “Online shopping is a $200 million business that has the potential to increase to $4.8 billion annually by 1998.”

As it turns out, Eager’s prediction was too conservative. The year 1998 ended up being a pivotal one for online shopping as it transitioned from technology-minded consumers to mainstream consumers. According to a report by the Boston Consulting Group released in December 1998, online shopping generated $4.4 billion in the first six months of the year alone. That number was expected to jump to more than $13 billion by the time the year was out and holiday shopping was factored in.

The late 1990s and early 2000s are remembered as the era when the dot-com bubble finally popped. But that wasn’t the case for online retail shopping, which continued to grow every year. There was a lot of blood in the water as traditional retail businesses came online and challenged the web-only sites for market share, but total spending grew and continues to grow today at a rate that would have been unfathomable to most of us just 20 years earlier. By 1999, online spending had doubled to $27 billion and grew again to $45 billion in 2000. By 2013, business-to-consumer online retail sales accounted for $803.76 billion in total revenue, a figure that is doubled when you account for online business-to-business transactions.

The early visions of an Internet economy have been fulfilled. We buy everything from clothes to music to cars, even our pets, online. Buying something online is no longer a novelty; it is expected. People who haven’t bought anything online are an increasingly rare breed—even a sizable portion of the elderly have purchased something online.

Many of the early Internet pioneers envisioned an Internet with its own currency. “The Internet is global,” they argued. For a global, instant, and digital economy to run correctly, we need a global, instant, and digital currency to go along with it. If Bitcoin doesn’t evolve any further, it will still be all of these things. It already is a global currency that is instant and, like the Internet, open for use by nearly everyone. Early Internet pioneers did not talk about the speculative possibilities that the Bitcoin ecosystem is so obsessed with today. That unfortunate aspect of the Bitcoin culture only arose after the wild price swings.

Kevin Kelly, the first executive editor of Wired magazine, predicted the development of an electronic money system and the effect it would have on our world in his 1994 book Out of Control: The New Biology of Machines, Social Systems and the Economic World. Kelly wrote:

By its decentralized, distributed nature, encrypted emoney has the same potential for transforming economic structure as personal computers did for overhauling management and communication structure. Most importantly, the privacy/security innovations needed for emoney are instrumental in developing the next level of adaptive complexity in an information-based society. I’d go so far as to say that truly digital money—or, more accurately, the economic mechanics needed for truly digital cash—will rewire the nature of our economy, communications, and knowledge.

Although predictions related to how much time and money we would spend online were fulfilled, the Internet never got its own currency. There were attempts but the centralized nature of the currency issuer always made emoney incompatible with the decentralized nature of the Internet. Some currencies failed because the company issuing them merely acted as money transactors themselves, adding an unnecessary middleman instead of eliminating one. Others failed because the issuer abused their power and scammed those who had bought in. Yet others ran afoul of government regulations. These issues are avoided with decentralization.

When Satoshi Nakamoto invented the blockchain by combining the distributed ledger and proof-of-work concepts, he fulfilled the long-held vision of a workable, distributed, decentralized currency for the Internet. With it, anyone can transfer virtually any amount for a few cents or less. The blockchain tracks every transaction and its distributed nature ensures that no government agency can shut it down. The details of how this works will be covered in another chapter but the first use case of Bitcoin and the blockchain is the ability to transfer value on the Internet as easily as sending an email and almost as cheaply. More uses for the blockchain are being developed every day but this is the most obvious. Many experts have called money transfer the first “application” of the blockchain; however, even that one application has near-endless uses.

Using the QR code found in the front of this book, any reader with a Bitcoin wallet can send bitcoins to me, the author. No banking institution needs to approve it; it doesn’t matter where you are or when you are reading this. If I still have access to the wallet, I can receive the money. In fact, regardless of whether I have access to that wallet, any user can send money to that address at any time for as long as the Bitcoin blockchain is in existence.

This might not sound impressive. After all, banks can transfer money. The banks will take their cuts but there are ways people can send money digitally using the legacy system. However, the difference between having to ask for permission and not having to ask for permission is not a small one. Using Bitcoin, any user can send any amount of money to any business or any individual in the world with a Bitcoin wallet, without restrictions.

If someone in Russia wants to launch a crowdfunding project, he or she has to find a service that can deposit money into a Russian bank account and then move it to a crowdfunding site that will either deny or approve his or her project. Then that site will take its own cut simply for connecting investors and inventors. Bitcoin can cut out those middlemen. Using Bitcoin, people can send someone money without asking for permission from anyone.

This is also a freedom issue. Centralized and legacy systems have the ability to prevent users from sending money to certain entities. At the height of the controversy over a leaked video showing American helicopter pilots joking while shooting people who seemed to be civilians, for instance, whistle-blower site Wikileaks lost PayPal and credit card support. Although there might not be any legal basis for this type of ban, individual companies can decide to prevent individual people from sending money to support causes they believe in. Bitcoin, along with a strong legal defence, has helped these individuals get around such bans. With no central power to prevent users from sending money to a specific entity, users can send their bitcoins to whatever because they fancy.

Bitcoin has the potential to cut out not only Internet-based middlemen but real-world ones as well. Walmart buys a lot of goods from China. There is significant markup added to the items in order to keep Walmart’s profits high. But do we really need them? Using the Internet and Bitcoin, I can easily send money to anyone in China. The recipient doesn’t have to worry about setting up a system that accepts American credit cards and can make deposits into a Chinese bank account. I can simply buy bitcoins with dollars and send them to a business owner in China, who then converts them to yuan. The fees, if any, could be much lower than sending money via Western Union or credit card. In fact, the biggest potential for fees comes when interacting with the legacy banking system—converting from dollars to bitcoins and then from bitcoins to yuan.

Think about how this can change the global economy. In the past, world leaders—for better or worse—have been pushing us toward globalization. With free trade eliminating tariffs, the workforce moved from regional to global at a rapid pace. This, few would deny, has been less than favorable for many American workers. Those workers are getting beat out by cheap labour in Latin America and Asia, and the profits are increasingly being passed on to the middlemen who facilitate deals between sweatshop labourers and American consumers.

Whatever your view on free trade, the hurdles that increase costs—what is often called friction by economists—are not helpful. If we are to have a global economy, we need a global currency. Removing middlemen and enabling money to be transferred directly from producer to consumer can greatly expedite this process. It also enables cottage industries by allowing them to sell directly to consumers worldwide without intermediaries. Hopefully, these will turn into sustainable industries that treat their employees fairly, increasing worker leverage in their region and eventually worldwide.

On a more basic and immediate level, Bitcoin allows for low-cost remittance. Sending money from first world countries where banking is relatively accessible to third world countries where it is not can be very expensive. The highest fees are nearly 50 percent and average around nine percent. With $316 billion sent from migrant workers to their home countries in 2009, those fees add up to billions of dollars sucked up by middlemen that could otherwise contribute to local economies. Bitcoin can replace those middlemen.

Lending is another example of how Bitcoin can make a big difference. Microloans are becoming more popular online as a way for small-time investors to grow their money while helping individuals by allowing them to avoid exorbitant interest rates charged by loan companies.

BTCJam and similar services allow investors to fund borrowers for everything from business plans to personal projects. Loans can be denominated in both Bitcoin and dollars. While BTCJam is a middleman, cutting out the credit card and money-transferring middlemen enable it to operate while only taking a one to five percent fee from the borrowers. This removal of friction enables more investments and more payments.

Another service cryptocurrency can theoretically provide is the role of arbitrator in any transaction. BitHalo, the Bitcoin half of BlackHalo, was the first instance of workable smart contracts, which are regulated by computer code rather than legal force. Smart contracts enable the sale of physical goods without either party needing to trust the other. BlackHalo was designed for Blackcoin, an alternative cryptocurrency. BitHalo has the same functionality but works with Bitcoin. It enables quick transfers between the two currencies.

More importantly, BitHalo allows for a decentralized marketplace without the need for a third-party arbitrator like eBay or PayPal. While Bitcoin on its own allows for the direct sale of goods and services from merchant to buyer, there is no way for anyone to settle disputes. Once Bitcoin is sent, it is under the control of the recipient and if a seller neglects to send the product or provide the service, there is very little the buyer can do about it. BitHalo fixes this problem by taking human nature into account. Each party is expected to put down a deposit separate from the actual transaction.

Both deposits and the buyer’s money are held in escrow controlled by the program itself. Once both sides approve the transaction, the buyer’s money will be transferred to the seller and deposits will be returned to both users. If both users agree to cancel the transaction, the money will be returned to the buyer and both deposits will be returned to their respective owners. However, when both parties can’t agree to cancel by a predetermined date, their deposits are lost and sent to a wallet with no retrievable address. The funds are essentially removed from the Bitcoin ecosystem.

Used properly, BitHalo gives sellers and buyers confidence that the other party is dedicated to making sure the transaction comes to an agreeable end. If the deposit is worth three times the actual transaction, neither side gains by trying the scam the other. Although scams and intimidation tactics might still be used on occasion, this system provides a workable method of ensuring trust in a decentralized marketplace.

The problem with BitHalo, however, is that no one is using it. With no one filling the marketplace, there is little reason for buyers or sellers to download the software. Beautiful ideas are not always beautifully implemented. This has been an issue with a number of Bitcoin-related projects.

OpenBazaar is a promising project that has been explained as Bittorrent to the Silk Road’s Napster. Unlike the Silk Road, OpenBazaar is decentralized, like Bitcoin itself, meaning there is no one server that the government can shut down to close it. It is based off the code called Darkmarket that was created by Amir Taaki and a team of other developers. Brian Hoffman forked Darkmarket and turned it into OpenBazaar, which uses the same principles but on the surface seems to be distancing itself from the Silk Road. 

At the same time, there are no rules in place preventing the sale of anything, nor can there be with the software. What OpenBazaar ultimately becomes—be it a decentralized Amazon or eBay, or something edgier, like a decentralized Silk Road—remains to be seen. The project is in alpha right now and cannot be used by the average consumer, though this may no longer be the case by the time this book hits store shelves.

Still, there is more to Bitcoin than transactions between parties. As mentioned, Bitcoin doesn’t just bring basic banking to those without banking access; it also has the potential to bring advanced banking abilities to users around the world.

Bitcoin 2.0 projects, as they are often called, can involve Bitcoin or other cryptocurrencies. The main idea behind these projects is that the blockchain and blockchain technologies can be used to transfer and keep track of holdings of valuables other than Bitcoin or other digital currencies. Even if a 2.0 project is not built off of Bitcoin, like Ethereum, increased investment and interest in cryptocurrencies as a whole tend to increase Bitcoin’s value as well. Since Bitcoin is currently the most successful, secure, and popular cryptocurrency, any increased interest in cryptocurrencies as a whole has a positive effect on Bitcoin’s price.

The first example of a “2.0” cryptocurrency was Namecoin, which, in addition to being a currency, acted as a distributed domain name registrar free from the control of any government, individual or group. Users need to download the Namecoin blockchain in order to view sites registered using the Namecoin protocol. Sites on the Namecoin network use the .bit domain extension. Unlike.com, .net, .org, or other domain extensions you normally see on the web, .bit registrations are not issued or controlled by a central entity. Instead, they are issued by the Namecoin network and no entity has the power to seize a .bit website registration.

Namecoin was the first example of a Bitcoin 2.0 project but there have been others. Counterparty, Ethereum, Masterparty, and Nxt are on the forefront of crowdfunding and crowd-investing. While all these platforms are different, they essentially allow the same thing: users can issue their own assets that can represent various things other than money, including ownership in a company.

Although most assets have so far been used in a way similar to traditional crowdfunding or investing, there are many other possibilities. Distributed Automated Corporations (DACs) are something nearly the entire cryptocommunity is excited about. Like all corporations, DACs are entities that exist to make money. Unlike most corporations, however, DACs don’t have any employees.

Instead, a DAC runs itself using code. It finds an activity online that can create profit, such as watching advertisements, and performs it over and over again. Its ownership is cryptographically linked to the individuals who hold the DAC’s assets through Bitcoin or another cryptocurrency and its profits are distributed to them. A DAC can be many things; the only qualification is that once it is set up, it has to be able to run with minimal or no outside influence. As the technology evolves, it is feasible that a great number of people could own DACs and that these could provide a secondary and passive stream of income for their owners. If this is sustainable remains to be seen— “free” money is rarely free and I don’t think our society is ready for a world without real work, but DACs still present some interesting possibilities.

It is not only Internet-created corporations that Bitcoin and blockchain technologies have given us the ability to invest in. Traditional finance is also being opened up to those who previously lacked the connections and funds needed to invest. Uphold (previously known as Bitreserve), BitGold, and several other services allow users to invest and hold precious metals or even other fiat currencies. In the case of Uphold, 27 different fiat currencies and precious metals are supported in addition to four digital currencies (Bitcoin, Litecoin, Ether, and Uphold’s own Voxelus). 

Uphold opens up investment opportunities that would otherwise be unavailable to the average consumer without enough disposable income to make a large initial investment and deal with significant fees. Uphold has recently removed fees for all verified customers—those who prove their identity by uploading personal documents—for fiat currency conversion.

The two services described above allow the quick transfer between precious materials or fiat and Bitcoin. Other companies allow users to trade stocks using Bitcoin as collateral. The stock market is no longer limited to investment bankers and those who can afford high minimum deposits required by various sites.

Bitcoin gives users an investment vehicle that was previously reserved for those in the upper middle class and above. Bitcoin users can invest their spare change into a range of commodities almost instantly. If a user decides they want to get rid of their investment or simply spend some of it, they can also do so almost instantly without incurring exorbitant fees. It is also possible to “invest” less than a penny.

The uses I’ve described so far, while not all strictly involving sending money back and forth, are still financial in nature. But the blockchain can do much more than that. It can store documents in a secure cryptographic manner. A user could encrypt a digital copy of their passport, store the hash of that file on the blockchain and then use that copy as a backup. Two users could record their marriage on the blockchain; in fact, this has already happened. Nearly every official document or contract that needs a notary could be stored on the blockchain and while it might not be recognized legally as such, it is far harder to forge a blockchain transaction than a notarized document.

The utility could potentially go beyond the financial. Decentralized cloud storage is also a possibility using blockchain technology. Storj doesn’t run on the Bitcoin blockchain; it runs on the CounterParty system, a coin and set of financial services built on top of but separate from the Bitcoin blockchain. Storj intends to create a storage system using the public ledger and cryptographic tools pioneered by Bitcoin.

Meanwhile, the infamous Kim Dotcom, known for his previous Megaupload.com and his current Mega.co.nz, has been teasing an “IP-less” Internet that will use blockchain or Bitcoin technology in some way, though news has seemingly slowed on that front.

It is impossible to name all the uses of Bitcoin, just as it is impossible to name all the uses for the computer. Just as a computer has unlimited uses because it is programmable, Bitcoin, as programmable money, is very versatile. By the time you read this, there will undoubtedly be more uses for Bitcoin.

New tools are being created for use on the Bitcoin blockchain or a related technology every day. And Bitcoin is just one of the thousands of cryptocurrencies in existence. It was the first, however, and it remains the most valuable, popular, and useful of all digital currencies. Bitcoin’s utility is limited only by the talent of its developers and the funding that gives them the time to work on it. Ultimately, this is also what determines its value. 

If Bitcoin wants to compete with Apple Pay, PayPal, Google Wallet, and the rest, its open-source developers—I don’t just mean the core developers but all developers working on related projects—need to provide more utility for Bitcoin than is currently available, in whatever form is important to the consumer. That is what it always comes down to in technology. There is no reason to think Bitcoin is any different.

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