As of time of this writing, Bitcoin have just smashed through $14000, $15000, $16000, $17000, $16500 with a year to date yield of over 1000%. It is dominating all other yields in a year where general market trend almost everywhere has been bullish, with global equities valuations pushing all time highs.

 

Bitcoin is a David and Goliath story. It’s a story of an unlikely invention by a mysterious genius reshaping the realms of finance, taking out the financial middleman and bringing a decentralized left hook straight to the mouths of the centralized financial systems of the world. It is digital gold.

Or it was supposed to have been.

Yes, bitcoin is enjoying an absolutely meteoric rise in its dollar term worth. Yes, the blockchain is a revolutionary idea that has the potential to reshape the world like the Internet did. But it is important to remember that the Internet revolutionized in ways and only in ways that nobody initially thought it could ever do. In other words, almost all of the successful functions of the Internet of today, from social media, to YouTube, to Wikipedia, and e-commerce were not planned or even imagined at its inception. The reasons for that are too many to explore here. This however, brings me to my first argument of skepticism towards bitcoin, that people are confounding bitcoin with blockchains. To make the analogy simple, if we’re going to call Blockchain the Internet, then Bitcoin is just one function of the Internet, and it has just as much chance of being the next Google as it does the next Pets.com. It would be foolish right now to try to predict which of the forking paths bitcoin will take and where bitcoin will end up in the future. Bitcoin and all other cryptocurrency is currently a use of the blockchain technology, but blockchain technology and all of its other potential uses far surpasses mere cryptocurrencies. Again, to use the analogy to the Internet, yes you can use the Internet to send encrypted electronic mail to your friends, but that’s not all the Internet does. In short, the survival of bitcoin is not necessary for the success of the blockchain technology, and the argument that blockchain is going to elevate bitcoin into the stratosphere actually severely underestimates the potential of the blockchain.

The second point of skepticism I have towards the future of bitcoin has to do, and I apologize for the sickly pun, with futures. Both the Chicago Mercantile Exchange and the Chicago Board Options Exchange have both recently announced that future contracts will be standardized and clearinghoused through both exchanges. This is extremely important news for bitcoin as the presence of such derivatives, as well as the institutional investors such derivatives bring can have profound effects on the prices of the underlying bitcoin. As of right now, I do not have a clue how the futures will affect Bitcoin, but it is certain that an additional layer of complexity is entering the game, and with additional complexity comes additional risks, even in the underlying market.

Thirdly, the most troubling question I have for bitcoin is in regards to the state of its original function, a cryptographically secured digital currency. I believe I see a very fundamental problem in that almost all supporting arguments for bitcoin (aside from those touting the potential of the blockchain) are advocating for bitcoin the currency, not bitcoin the tradable asset. I believe that this current spectacular boom can be explained by the market’s lack of awareness of this confounding problem, and will have huge corrections once this error is realized. So we will explore what it is that bitcoin was originally intended to be, and what it is now.

Bitcoin was supposed to be money. For something to be money, it must serve a few basic functions:

• Unit of Account: Money need to be numerical, as it functions to assign an arithmetical relationship between different objects in the world. Divisibility is of utmost importance here and is why a cow is a bad form of payment, because you can’t pay in ½ of a cow without killing it.
• Medium of Exchange: Money need to be widely trusted by people as something that can be exchanged for many other things. This function of money is crucial and can be visualized in a thought experiment to the time of the barter system. If we imagine that I have some extra wheat and you happen to want to bake a loaf of bread today. You have some grapes that I would like to eat immediately. I will then, after reaching a deal, exchange with you a certain amount of my wheat for some of your grapes. However, because the wheat does not perish as easily as grapes, if I gave you more wheat than you needed for the bread today, you will be able to keep the grain for longer and potentially consume it later or exchange it for something else with another person later on. But as for the grapes, if I don’t finish those within a couple of days, I had better start turning them into raisins. So there is a much smaller chance that I will be able to use the grapes for exchanges in the future. Thus over time, it is not hard to imagine that more and more wheat makes it to more and more people’s households from exchanges like this and become the exchange medium of the village. Eventually, wheat will become so widely exchanged not just because of its value to make bread, but also because of everyone’s trust in the ability of wheat to be exchanged for almost anything else. This trust is crucial, and for this trust to develop, the commodity must have some durability, as well as divisibility, and portability. However, we can see from this thought experiment that in a decentralized bartering system, what allows a commodity to be come a medium of exchange in the first place is that it possesses certain intrinsic value in of itself. This initial intrinsic value can be an aesthetic value (e.g. pretty seashells, shiny precious metals,) simple scarcity (rare gems,) or actual utility value that nonprecious metals or wheat has to offer. Without this initial intrinsic value, people would never have exchanged for it in the first place. Would you accept a random common pebble for the grapes? Even though small rocks are durable, portable, and divisible, without this initial intrinsic value, it can never get started as a medium of exchange. So in a completely decentralized system, which is what bitcoin want to operate in, the value of money can be described as the sum of its intrinsic value (e.g. wheat as bread ingredient) plus its accepted value as a medium of exchange (e.g. wheat as currency). This explains why precious metal eventually took over as the de facto money in history. They don’t degrade, they’re easy enough to carry around, they’re scarce, they’re divisible, and they have just enough intrinsic value that people wanted them for what they are in the initial barters. In the advent of fiat paper money later in modernity, the intrinsic values dropped to zero, and the exchange value for these new fiat money became its sole value, and resides in the government’s power to enforce (via violence) contracts and tax. Thus we can have illogical situations like how the value of the metal content in a nickel coin is actually greater than 5 cents, but you can never use it as such without melting it down, which is technically illegal. This type of situation would never arise in a decentralized system, as there would simply never be any entity intentionally taking losses to force nickels to be worth 5 cents. This centralized monetary system was the beast that bitcoin the currency took aim to bring down.
  • Now some have argued a bartering system probably never existed (See David Graeber’s book Debt: First 5000 Years). It was just simply not a very practical system if you really think about how it would function. For example, bartering would work terribly in a situation where I need some chickens today and have a pig to exchange for it, but you don’t want another pig today. With pigs being not very durable, divisible, and portable, it never had a chance to become a medium of exchange. The only way to solve this problem is to find a third (or fourth, or fifth, etc) party that want my pig and have a bottle of wine that you want to complete this trade in a barter system. An example of this inefficiency in barter is the trades that occur in the NBA where a 3^rd team is often necessary to facilitate the player swaps, and these trades take days to complete. The source of the limitation to a pure bartering system is in the timing, because bartering requires all involved parties to make the exchange at the exact same time. Graeber argued that it is much easier for a small economy to get started with a rudimentary credits system instead. How that would work is that if I needed a chicken, but you don’t want the extra pig right now, I’d just come to you and ask for the extra chicken that you have today. You’d give the chicken to me and we would both keep an informal IOU that “I owe you something roughly the value of a chicken.” Later on when you find out that I have traded away my extra pig and received a few bottles of wine that you would want to drink, you simply just come to my house and just ask for a bottle, and I will gladly give it to you, for the chicken that you gave me a while ago. Our informal IOU is cleared and we both move on with our lives. This is what a rudimentary credit system looks like, where the credit exist to allow for inter-temporal trades. This system works much more efficiently than a pure barter, as long as each participant can assess counterparty credit risk well enough. The increased complexity here compared with pure barter is the presence of credit risk. While bartering is inefficient, the very inefficiency eliminates the opportunities for any party to receive something then refuse to pay back for it. So it is important that in a rudimentary credit system, that people only participate with people whose creditworthiness that they know well. The limitation due to credit risk in a rudimentary credit system is obvious once you need to trade with a stranger in the next town over. Once you have to trade with people that you do not know personally, a system of common and trusted medium of exchange must necessarily emerge, to lessen the need to assess creditworthiness.
• Storage of value: Lastly, money should be able to hold it purchasing power consistently and predictably. In short, if I exchange a bushel of wheat for 5 chickens today, should I want 5 more chickens tomorrow given that there are enough chickens available (jargon: if the liquidity is strong), I expect to be able to exchange for 5 additional chickens with 1 additional bushel of wheat. It would cause a major problem for wheat as money if I find tomorrow that my 1 bushel of wheat can only exchange for 2 chickens. Without an ability to uphold to the expectations of money to store value consistently, it becomes very risky to give and accept the currency.

Now let’s see how these functions apply to Bitcoin.

• Unit of Account: Bitcoin does this exceptionally well, much better than any other currencies of the past. Due to its digital nature, it is easily countable and divisible into the most infinitesimal of units.
• Medium of Exchange: The most accepted currency in America is still the fiat dollar, and you’d be hard pressed to find too many places accepting bitcoin. But to be fair, it’s almost impossible to get anybody accept anything other than dollar as payment these days as well. It is the battle that bitcoin the currency is trying to fight. The government has a monopoly on money production and money transaction. Almost all transactions within the United States is dollar-denominated and recorded and reported to the IRS for tax purposes. The government has centralized currencies and the many financial infrastructures used to facilitate transactions. As with any monopoly, the government also instituted many rigid bureaucratic rules and regulations in order to protect their monopoly in creating money and its facilitation. Both private and public institutions take advantage of the inefficiencies in these regulations, but ultimately it must use the governmental financial infrastructures, as there aren’t any alternatives. The initial idea of bitcoin the currency was that it has created through cryptography and blockchain, new form of private money that exists on the Internet. This new form of private money bypasses all of the present governmental financial infrastructures, and presents users the ability to make exchanges without paying the proverbial toll to use the highways that the government has set up for all financial transactions. The key to any commodity of becoming a medium of exchange is its widespread adoption, and this is the hurdle that bitcoin the currency have yet to be able to overcome. The reason for this slow adoption is multi-fold, and is too long to be discussed here. I will only discuss one reason, which is related to bitcoin’s problem as storage of value.
• Storage of value: This is where bitcoin has its biggest issues at becoming as a bona fide currency. As described above, for something to be accepted as mediums of exchange, it cannot have wild fluctuations in its value storage. Regardless of your opinion on bitcoin, one undeniable fact is this: a bitcoin today is probably not going to hold the same purchasing power as a bitcoin tomorrow. Usually with most money, it is the inflationary risk that’s worrisome. If a currency is continuously losing value at a rapid rate, you’d want to spend it quick and exchange for something that holds its value more stably, and you’d be hard pressed to exchange anything for such a currency. So you’d have excessive supply of the faltering currency with no demand, which reflexively lead to further decline in purchasing power of the currency. This is how economies falls apart in times of hyperinflation. This current situation in bitcoin presents the opposite. The bitcoin rocket ship blasting upward with no end in sight means that nobody is willing to spend bitcoin as a currency. Because should you use it as currency, you run the very real risk of paying an exorbitant amount in futures dollars for something like a pizza as somebody did in 2010 (@bitcoin_pizza on twitter). In this situation, supply of bitcoin the currency sharply decrease, and demand for it sharply rises, which reflexively leads to further increase in bitcoin’s dollar-price. Because its value is not stable, nobody is using bitcoin to buy things. Because nobody is using bitcoin the buy things, it is not a medium of exchange, and it is thus not money.

The idea of the bitcoin the currency is wonderful. What bitcoin and other cryptocurrencies revealed, is the postmodern idea that a lot of iron laws of society are simply illusions. In the movie Margin Call, there was a line that I think will resonate with every bitcoin bull. “It’s just money. It’s made up. Piece of paper with faces on it so we don’t have to kill each other just to get something to eat.” What bitcoin shouted to the world is that money is nothing but a made-up medium of exchange that holds value and numerates thing. So what bitcoin aimed to do was to create a decentralized and nonphysical medium of exchange on the Internet, where the intrinsic value would be the utility of an entirely new alternative paradigm to the governmental monopoly over financial transactions. If this is combined with widespread acceptance, it can easily become an extreme force to reckon within society.

As most bitcoin bull will tell you, it is this incredible potential to uproot the entire financial system as a new currency that gives bitcoin the ammunition to sustain this momentous rally. But the ironic reality is that it is precisely this meteoric rise and incredible volatility in its dollar term worth that has made bitcoin far too volatile to function as a currency. The original vision of bitcoin was for it to untether from the dollar and become alternative private money for private transactions bypassing governmental interferences. This current version of bitcoin is little more than a increasingly scarce commodity whose demand far outstrips the supply in the market, with classic positive feedback mechanism reinforcing this scarcity. By being a valuable idea, the idea suffocated itself. It is this unfortunate piece of reflexivity that gives me the opinion that bitcoin be currently looked upon as a commodity with epistemologically opaque fundamental valuation, and not a currency. Thus if the above arguments are true, then we must realize that all recent price action have been driven by speculative pressure towards a false paradise, and not for any realization of revolutionary fundamental value. Icarus, meet bitcoin.

I love the idea of bitcoin, of cryptocurrencies and of the blockchain. In an age of increased governmental involvement in people’s private lives and decreased liberty, the emergence of the blockchain glimmers brightly in the dark. So allow me to be skeptical of my own skepticism and offer a few lines of speculative gibberish on where I see things going potentially.

As I have stated above, the fundamental value of bitcoin the asset is unknown and unknowable at present times, but we know that it is associated with the blockchain technology. The fact that my first argument points to that success of the blockchain do not necessitate the survival of bitcoin does not invalidate the possibility of such a contiguity. My thesis is that I do not think the probability of bitcoin becoming the revolutionary new currency is very high given its current inability to store value, and that the arguments made by bitcoin bulls that cite bitcoin the asset’s rally as evidence of bitcoin’s future utility is logically fallacious. Also due to the exposure of bitcoin, a large correction now would almost certainly damage bitcoin’s reputation and its adoption as a currency in the future. However, I do not believe that even if such a correction is to occur, that it would mean certain death for bitcoin. Stranger things have happened in this world. I think at this point, the practical approach towards the future of bitcoin (and i would argue the future of anything) is agnosticism. All I have said is that at these current prices and more importantly, the rate at which these prices have been climbing, odds are high that this is simply speculative build up. However, if more information is to present itself, such as the appearances of people actually using bitcoins as mediums of exchanges, that should signal one to change their minds. The ultimate beauty of the human mind is not in its rationality, but rather its adaptability to a changing world. When information change, one’s opinion should change.