Sean King

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Knoxville, Tennessee, United States

Saturday, November 16, 2013

A Bitcoin White Paper for Laypersons

Introduction

There is much debate about whether bitcoin is real money. Detractors, such as @TheStalwart, argue that bitcoins are not backed by anything and therefore cannot be, or at least cannot long survive as, money. Bitcoin advocates counter that the US Dollar also isn’t backed by anything and therefore likewise has no inherent value, and yet it works reasonably well (so far) as money. Is the dollar therefore doomed to fail?

Some Bitcoin detractors say yes—i.e., that dollars will eventually fail just like Bitcoin will fail (since nothing without at least some inherent value can survive forever as money, they argue). Other bitcoin detractors say no--that dollars are actually backed by government fiat and can therefor be used, for example, to pay one’s mandatory taxes. They insist that the dollar’s role as “legal tender” is a sufficient substitute inherent value, or that this fiat in fact creates inherent value. Some in this camp also point out that dollars are actually backed by debt—that is, that they represent a claim on someone else’s goods or services--and therefore have some inherent value for that reason as well. 

However, when the debate over Bitcoin is framed in the manner described above, as it so often is, both Bitcoin's detractors and advocates are wrong.  For, as we shall see, bitcoins are inherently valuable.


The Origins of Inherent Value

When people debate whether or not a given thing has “inherent value”, at least in the common sense, what they really mean to debate is whether or not the thing has utility separate and apart from its dollar value. Dollar value is simply a function of supply and demand, and as a result varies based upon the whims of mass psychology (being subject to manias, bubbles, fads and depressions, for example).

But something is inherently valuable if it is both sufficiently scarce and useful for some important human purpose. For instance, hammers are exceedingly useful at putting nails in boards and building shelters (very important to survival). If the laws of nature, or of math, made hammers sufficiently scarce (and if competing air guns were not available), hammers would have considerable “inherent value”—that is, people would pay good money for them (regardless of fad, fashion or branding), and for good reason .

On the other hand, Beanie Babies have very little “inherent value’, though they were worth good money at one point simply because of supply and demand. Lots of people wanted them, and they were in reasonably short supply. So, prices skyrocketed for a while.  But unlike hammers, people wanted Beanie Babies not because they were particularly useful for some important purpose, but because: (1) They gained some momentary enjoyment by looking at and possessing them, or (2) because other people wanted them (that is, they were a fad). But, you couldn’t eat Beanie Babies. You couldn’t really use them to build shelter. Perhaps if you had enough of them they would keep you warm, but there are better and less expensive alternatives for warmth. In short, unlike hammers, Beanie Babies had no inherent utility.

The examples above (and Economics 101) teach us that, as long as something is useful for an important purpose and reasonably scarce, the law of supply and demand requires that it will have a price floor. When something is very useful to lots of people and relatively scarce, its price floor (or inherent value) will be relatively high. When something is only useful to a few people, and is also in great supply, that price floor will be low. Even when something is useful to everyone (like air, for example), its price floor will be exceedingly low it if is nonetheless ubiquitous.  In short, the practical utility and scarcity of a good or commodity combine to set a floor on price. The more useful and scarce something is, the greater its “inherent value”. Goods or commodities with little to no floor will tend to be quite volatile in price, even when widely traded, since their value at any given moment is almost purely dependent upon mass psychology, which always changes.

The questions that this paper attempts to answer are simply these: Are bitcoins more like a scare hammer or a Beanie Baby? That is do they have inhernet value? And, if they so, are they likely to become money?

As I shall demonstrate, bitcoins are perhaps one of the most inherently valuable inventions of the last century. Bitcoins stand ready to disrupt many of the world’s oldest business models, and not because they are money (yet). But, if they are successful in disrupting these archaic businesses, their ready tradability and certain other unique characteristics make it likely that they will eventually circulate as money on a global scale.


Bitcoin is Inherently Valuable

To understand why this is so, an extended analogy is required:

Imagine that I am the creator of a new invention: Reusable, magical shipping packages. Further imagine that these packages, which are in limited supply, permit their holders to anonymously transfer goods to any person in the world (wherever the receiver may be at a given moment, even if the sender doesn’t know where that may be or even who, exactly, the receiver is!), nearly instantaneously, with complete reliability and security (so that no one else can intercept the package or tamper with it along the way), and at virtually no cost. In short, these magical packages that I have invented are scarce (in limited supply), durable (they don’t degrade and can be reused), completely reliable (so no return or shipping address is needed and shipper anonymity is therefore preserved, if desired), and impossible to counterfeit or replicate.

Also, imagine that these packages come in different sizes so that one can use them to ship things from the size of a standard shipping container down to the size of a grain of sand.


Sound useful? 

Would such containers have inherent utility and therefore value?

Of course.  They are both exceedingly useful and also very scarce.

In fact, were they to exist, everyone would start using them immediately, right? The shipping industry would dry up over night. Sea going shipping vessels, river barges, and even long-haul truckers would become largely useless and unnecessary. Billions upon billions of dollars currently spent on shipping could be freed up and used for better purposes.

Right?


Here’s the Catch 

Well…not exactly. You see, there are a couple “catches” to these magical containers that, at first, impede their immediate, widespread adoption by the general public and limit their initial value.

First, using these packages requires a little skill. To send these shipping packages, a sender must spend about five hours learning certain magical “sending” incantations. And the receiver must likewise spend about five hours memorizing the magical “receiving” incantations that serve to open the package upon its delivery. Unless both the sender and receiver of a given package have taken the time to learn the necessary incantations, the packages are useless to them for shipping and receiving goods.

And second, remember that such packages are available only in limited numbers. Very limited numbers at first. And Jane or Joe Public aren't likely to invest the ten hours necessary to learn how to use these things until each actually…you know…receives one or has some opportunity to use one. And...that may take a while.

So, adoption of even a revolutionary technology, like our magical shipping packages, begins more slowly than most anticipate but then rapidly makes up for lost time thanks to exponential compounding. To further illustrate why this is so, let me give a specific example.


An Illustrative Case Study 

Having just created the first two of these packages (about 21 million more are coming at a slow, predicable rate), I, their inventor, have decided that I want to use one of them to ship an iPhone and $100 in cash currency notes to my friend James (who unknown to me is on vacation in Paris). And I want to use the other to send a “thank you note” and a $5 Starbucks gift card to my friend Louisa two towns over.

Having memorized the sending incantations, I simply place my iPhone and $100 in one magical shipping package, and the gift card and thank you note in the other, speak the magic words, and then…wait. Within ten minutes or so, both packages magically find their intended recipients (anywhere in the world) with 100% reliability, and at essentially no cost to me or them. Also, because these packages are magic, no thief, no nosey neighbor, no government customs or revenue agent, nor anyone else can stop delivery, intercept the package or tamper with their contents along the way (or even know that I had sent them for that matter). Provided that my friends each invest the five hours necessary to learn the incantations to open these types of packages, which I will assist them to do, they will each receive a nice little surprise from me.

So…what is the most valuable thing that I sent to each of my friends above? Well, anyone with any degree of foresight would probably say…the reusable shipping packages! Eventually, once there are enough such packages in circulation, and once enough people know how to use them, the ability to ship any good anywhere in the world in the manner described above is going to be worth quite a bit, no? Maybe even more than the $100 in cash and the iPhone that I send James. Maybe a lot more.

But, for now, the market for these packages is not very “deep”. At this point, I (the inventor), James and Louisa are the only ones who know how to make use of them (let's assume that James and Louisa have learned to use them). If James offered his package on eBay to the highest bidder, would it sell for thousands or millions? Probably not at this point. Few in the world have even heard of the packages, and even those who have likely still struggle to believe in their potential.

So, if we don’t get these packages in circulation, and teach more people how to us them, their potential value as shipping vessels remains just that…potential. Demand, and therefore their dollar value, will only increase if we can get a sufficient number of people to believe in and use the packages.

Fortunately for us all, these particular containers benefit from the so-called “network effect”. Each new person who learns how to used them increases the value of the network exponentially, which provides additional incentive for me people to learn the technology.  For example, currently, I can send a package only to James and Louisa. James can send one only to Louisa and me. And Louisa can send one only to James and me. That’s only six possible “sendings”.  But, if we take the time to educate a fourth person on how to use them, an addition of only one additional user, the four of us can now send packages to three different people in our group, which represents the potential for twelve possible “sendings”. We added one person, and the number of possible sendings (i.e, their utility) doubled from six to twelve. That’s quite a bit of added value!

So…let’s assume that James does the rational thing and lists the package on eBay.  The higher bidder offers him $20, provided that James will provide instructions on how to use it. That’s not a huge sum, but it’s $20 more than he would have gotten had he (and Louisa and I) hoarded all of these for ourselves. And now he’s gotten another person to learn the technology, which increases its usefulness and value for everyone in the long run. 


Valuable Because They are Useful

It’s important to note here that, whatever modest value the packages may have on the “open market” at this point is a result of their utility--that is, they have intrinsic value as shipping vehicles to a limited but increasing number of people who know how to use them. They are not (at least not yet) useful simply because they have monetary value. This is a critical distinction to which I will return  time and again, for it is the distinction between a good or commodity and money. Goods and commodities can have a price floor (inherent value) because they are useful (that is, they have built in  utility). But money (or at least fiat money) is primarily valuable simply because it, as a matter of convention, can be traded for goods or commodities with inherent usefulness. Fiat money has no real inherent usefulness itself (other than maybe the fact that it can be burned in a fireplace for warmth).

Said another way, goods and commodities are valuable because they are useful, but (fiat) money is useful only because, by convention, it is valuable (until maybe one day it’s not).


Now, back to the story

Fortunately, thanks to the fact that James, Louisa and I, and some subsequent buyers, haven’t tried to hoard these packages, more and more people are exposed to them and begin to learn the shipping and receiving incantations for themselves.  In fact, in an effort to further incentivize the growth and adoption of these packages, suppose that I, their inventor, have decreed that all 21 million that are "created" in the future will be distributed via a lottery only to those who have taken the time to learn the magical sending and receiving incantations and can therefore benefit from using the packages.

With the incentives of rising price and the lottery, the exponential growth of the user base accelerates, and the value of these packages even more so (thanks to network effects). But, even so, large-scale mass adoption will still take some time. Since the exponential growth started from such a small base (one inventor), it is largely invisible to the wider world.

To illustrate why this is so, let’s assume that, due to the usefulness of the shipping method, the number of people taking the time to learn the magical incantations quadruples on average every quarter year. Beginning with one person (me, the inventor/founder of the magical packages), the number of people in the world knowing how to use these packages two years from their invention will only be a mere 65,500 (after eight quadruplings). But, in just another year after that, knowledgeable users will total almost 17 million persons (after four more quadruplings), and a year after that (after just four additional quadruplings), over half the world’s population will be shipping package “literate”!

And finally, less than a quarter year later, the whole world will be literate in shipping and receiving with the packages. So, in my example, it takes two years for the number of users to grow to 65,500.  But, just a little more than two years after that, the user base is comprised of the whole world! That’s the deceptive power of exponential growth and the network effect.


Fast Forward—Can’t Stop the Magic 

Let's pause for a moment and see what things look like when the user base is a mere 65,500 persons.

By this stage in the development of the packages, the price will have increased substantially as 65,500 people now bid for the constrained supply. More and more people are incentivized to learn the incarnations.

But many of these new users will have little or no need use the packages themselves. So, given that they have significant monetary value to others, packages will start to be traded (let's assume on eBay for now).  In fact, may be traded “empty” (that is, with no goods inside) an increasing percentage of the time as those with little use for them transfer them to those with great use.  For instance, these magical packages would be more useful to UPS or to Amazon than to me.  So, if I ever received one, I’d likely sell it to some other shipper rather than retain it for my personal use.

Eventually, small online exchanges are likely to develop to facilitate the easy purchase and sale of these packages (in most any currency) by knowledgeable buyers and sellers. Packages therefore come to be traded online just like other goods or commodities. Or currencies.  These exchanges act as a far more efficient price discovery mechanism, which serves to increase the overall value of these packages.  Rising values encourage more people to invest the time learning to use the packages.  


Global Market

Note that, because these packages can be sent anywhere in the world nearly instantly for free and are traded online, the market for them is truly global. This has great significance for a variety of reasons. For one, it results in worldwide price consistency—for instance, there won’t be much disparity in the price of a package whether it is purchased from a seller in Russia or one in Argentina. These packages are essentially worth the same amount anywhere in the world.

And second, because the packages have a global market and can be transferred nearly instantly in a way that governments cannot prevent, efforts to regulate them are almost certain to fail. Even if the old school shippers (owners and operators of barges, trucking companies, etc.) lobby politicians to ban or heavily regulate these magical shipping packages—for instance by arguing that the packages can be used to facilitate criminal activities like shipping drugs or avoiding customs—the extraordinary global usefulness of the packages insures their survival and continued growth. Any country banning the technology will almost certainly fail in its efforts (given the anti-fragile nature of the packages).  And, to the extent any jurisdiction was successful at banning it for reasons unforeseen, that jurisdiction would experience a rapid exodus of wealth in favor of other jurisdictions that tread lightly.  Capital is mobile, and even more so in the age of magical packages.


Volatility Subsides (Some) 

As the market becomes more and more global and liquid, and confident in the inability of the vested interests to ban or severely limit the usefulness of these magical packages, the prices of the packages, which had once been exceedingly volatile, begin over time to normalize. Prices are still volatile (as the market of only a few hundred thousand users is still very thin), but most of that volatility is on the "upside".  Less volatility leads to even higher prices, which in turn attracts even more interest.


Still Not Money

It is important to note that, at this stage in the (r)evolution of these magical packages, their price is still mostly a function of their usefulness. They are valuable because they are useful (as shipping packages). They are not (yet) particularly useful because because they are valuable (as money). That will change.


Left Behind

Perhaps a year later, as the number of people using these packages approaches 16 million mark, those people and businesses (or even countries) who have refused to embrace the new technology find themselves increasingly at a competitive disadvantage. Thus, even former holdouts (who objected to the potential illegal uses of these containers, for instance) become advocates of the technology, feeding the continued exponential rate of adoption, and fueling yet more demand. As demand rises, so does price (yet again).


Store of Value 

Note that, at this stage, the packages are starting to act as a “store of value”, one of the primary characteristics of “money”. Though the price may still be quite volatile (as the market is still not “deep” and the technology not widely understood), perhaps as volatile as a penny stock, the trend in price is unmistakably up.


Speculators

Some begin to speculate in packages, which sends their price even higher, making them even more appealing as a store of value.


Medium of Exchange 

After maybe "just" one more quadrupling or so, packages are starting to look more and more like money.  Businesses that benefit the most from having access to these packages, perhaps those that ship lots of goods (again, think Amazon or UPS, for example), begin seeking additional ways of obtaining the magical packages (other than purchasing them on the open market, which is getting expensive). Some businesses are willing to pay their suppliers more if the suppliers agree to ship goods to them in the magical, reusable containers. They may even offer discounts to their customers who offer up a magical package as “boot” in the purchase transaction.

And, at some point, an increasing number of businesses become willing to trade goods or services for packages outright without any actual “real money” changing hands.  No longer are packages simply “boot” in a sales transactions, they are the actual substance of it.

Eventually, demand for packages becomes so brisk that businesses are willing to offer ever-increasing amount of goods and services in exchange for the highly useful, and highly valuable, packages.  Thanks to this bidding war the “price” of the packages, measured in goods and services, continues to grow.  Some providers of services, even labor, may start offering discounts if payment is made in bitcoin.


Ending Theft

Packages, now being quite valuable, begin to be targets of theft. To prevent this, the public learns that they can add some extra words of their choice (passwords) onto the normal magical incantations that are needed to ship and receive the packages. Thus, without knowing both the normal shipping and receiving incantations, and the magical password linked to a given package, the packages are worthless to all but their current owner.  Subsequent owners will have to pay for the privilege of changing the password on a given package to his or her own. This advance in security makes the packages even more secure and useful in trade.  Which...you guessed it...increases their price even more.

A year or two ago, one large package may have been sufficient to buy a couple of large pizzas. Now, one large package buys a good smart phone or gets your attorney to draft a Will for you. A few months from now one large package may be enough to purchase a good computer or to pay your accountant for filing your business’s tax return. And maybe a year after that, one large package buys you a car.


Businesses Stop Selling 

Note that, up to this point, most businesses trading goods and services for packages (that don’t need to ship things often) sought to convert those packages into the local currency as quickly as possible to avoid exchange rate risk. After all, businesses need to use a significant portion of their revenue to buy more inventory, pay their employees, etc…. And, historically, most of their suppliers and virtually all of their employees demanded payment in dollars rather than packages. This regular selling of packages for dollars on the open market by businesses that receive them in trade (but have no need to use them for shipping) acts as somewhat of a damper on the ever-escalating price of packages. Prices of packages are rising quickly, but not as quickly as they could or would if there weren’t so many sellers.

But, eventually, maybe once half of the world is literate in use of the packages, a tipping point is reached. Enough suppliers, retailers, and even employees are all willing to accept payment for their goods and services in packages instead of fiat currency. Those who can may even start demanding it.

Thus, when one gets paid in packages, and can likewise pay for things in packages, there is increasingly little reason to endure the hassle, the cost, and the lack of privacy that comes from converting packages to fiat currency and back (other than to pay taxes, for example, which likely still requires fiat currency).

So, at this key juncture, the packages are increasingly taking on the characteristics of a “medium of exchange”, the second of three key attributes of “money”. People are often trading packages, empty, for goods and services at both the wholesale and retail levels. Even people who have little to no use for the packages as shipping containers now seek to obtain them because they are so convenient for use in trade and commerce, especially international trade and commerce.


Unit of Account 

As this trend continues, perhaps just a few months later when virtually the whole world is package literate, goods and services increasingly come to be “priced” in terms of packages, initially in addition to fiat currency. For instance, a new car might be priced at $25,000, or one large magical shipping package.

This dual pricing is likely to continue for some time.  But, eventually, perhaps after a decade or so, most people and businesses stop pricing things in terms of fiat currency altogether. (In fact, by this point, most fiat currency is probably worthless since it’s now largely rejected in favor of packages, which are much more portable, more secure, and more private).  Fiat just isn't worth the hassle (except maybe to pay one's taxes, assuming governments haven't started accepting packages by this point).

At this final stage in the (r)evolution of the packages, they have taken on the last attribute of “money”. That is, they now serve as a “unit of account”— a measure by which other goods and services are priced.


Bank Influence Declines 

Since packages are traded directly (and even anonymously) between parties via global online exchanges and the like, and since they can now be “locked down” with the use of passwords that render them unusable to all but their rightful owner, there is less and less use for bank accounts. Financial intermediaries, who historically made huge sums of money as custodians and transferors of money for people, have a diminishing role in commerce.

What banks still exist now accept the deposit of packages, and permit people to transfer rights to those packages, through the banking system (just like they currently allow people to transfer rights to dollars the same way). A significant percentage of packages are never actually used for shipping, but remain locked away in bank vaults, with people trading rights to them the same way they trade checks today. Even bank accounts are often denominated in packages rather than dollars.




A Quick Summary 

Originally, packages were valuable in trade because they were useful for a particular purpose (shipping), and they still are useful for that purpose. But, once the whole world is familiar with their use, their tradability, convenience of use, privacy and other unique attributes cause them to start taking on the attributes of money.

Their ongoing utility insured that they became a "store of value". Then, eventually, they became a "medium of exchange". And finally, they began to act as a "unit of account". People who have no need for the specific useful properties of the magical shipping packages nonetheless accept them in trade, as money, because they know that others will readily do the same. What was once valuable to a few only because it was useful to a few is now useful to many because it’s valuable to many. What was once a good, or a commodity, is now money. 


Bitcoin is a Magical Shipping Package! 

So, what’s the difference then between bitcoins and my magical shipping packages? Frankly not much. Really, just one thing: Bitcoins can’t actually be used to ship or transfer “real” things. Rather, they can only be used to ship or transfer virtual things—that is, information.

While this may at first seem like a major limitation to bitcoin’s potential usefulness and therefore its inherent value, it shouldn’t for at least three reasons. First, physical goods are increasingly being digitized into chunks of virtual information. Consider, for example, what has happened to music, books, office documents, and videos over the last decade. Or, to dollars over the last twenty years (after all, how often do we make use of physical currency these days?). With the imminent dawn of 3D printing, even physical goods will be soon be sent around the world in virtual, digital form, and the line between a virtual thing and a physical one will be increasingly blurred.

And second, note that the physical, magical packages suffer from limitations of their own that make them less than ideal for use as money, while virtual bitcoins do not. For instance, physical packages suffer from the burden of being…physical. Can you really imagine lugging twenty shipping packages down to your local Wal-Mart to purchase groceries? That’s not a problem with bitcoin as one can carry an infinite number of bitcoins on his/her smartphone.

And third, physical packages are not divisible, which also inhibits their ability to serve as a unit of account (where fine gradations in value must be available). Bitcoins, by contrast, are (currently) divisible to eight decimal places.


But, Can’t we Already Send Things Virtually?

Can’t we already send virtual information or dollars around the world through mediums such as the Internet, email, text messaging, wire transfers, etc.? Yes, we can. But not instantaneously, anonymously, completely securely, highly reliably, in a way that can’t be counterfeited or replicated or interfered with, in a way that can be publicly audited (to insure the integrity of the system), AND nearly for free. Bitcoin (and certain other “crypto-currencies”) uniquely offer this particular bundle of features, as we shall see.


But…How?

So, how does Bitcoin do all these things? Well, the actual explanation is quite complex (see the original Bitcoin Whitepaper for details. But, the practical one is, fortunately, more simple to explain (if one can forgive my liberal use of simplified analogies).

The Bitcoin system is simply a cryptographically secure distributed ledger—an accurate, chronological record of information--that exists, almost simultaneously, on thousands, if not millions, of computers across the world. Every computer that runs the bitcoin software, which anyone can download, becomes part of this peer-to-peer network and maintains an independent copy of the updated ledger book. This ledger book is called the “blockchain”.  All of these computers talk directly to each other (peer-to-peer) rather than through a central server.

The bitcoin network is currently the most powerful computer network on earth. By far.  But, not just anyone is permitted to use the network to make entries in the bitcoin blockchain ledger. Only people with signing authority can append information (or add a transaction) to the ledger.

They do so by inputting that information into the bitcoin software running on their computer, or any other computer in the world for that matter. That computer then notifies the others in the system connected to it of the latest authorized transaction, and they in turn notify others to which they are connected, and they yet others, until every computer attached to the network eventually contains an independent record of the last piece of information added (the last “transaction”) to the blockchain ledger.

Transactions are “authorized” and certified by the network via complex mathematical calculations. There are no human arbiters as to which transactions are valid and which are not. It’s all math.

If one computer in the network drops offline, crashes, is seized or impounded, or otherwise stops contributing to the network, it doesn’t matter. The others keep on going. If and when the offline computer rejoins the network, it simply gets an updated copy of the ledger from the other computers all across the world that have maintained it in its absence.


Who Can Use the Bitcoin Network?

So…who exactly has “signing authority” to update the ledger? The answer is: Anyone who has obtained possession of, and control over, a limited number of special writing utensils (each of which is called a ”Satoshi”). A collection of one hundred million satoshis is called a “bitcoin”. Thus, a single bitcoin, which can be used or sold in whole or in parts, permits its holder to enter 100 million transactions into the blockchain ledger!

For convenience and other reasons, this signing authority is traded in 100 million dollar units (again, called “bitcoins”), or fractions thereof. At the moment of this writing 1 bitcoin, or the right to sign the global distributed ledger 100 million times, is currently selling on global online exchanges for about $320 USD.

Currently there are approximately 11 million bitcoins in existence, and the system permits more to be created at a predetermined rate until the 21st million comes into existence. Complex math insures that, after 21 million, no others can or will ever be recognized by the network. In other words, there now is and always will be a fixed supply of bit coins.

Each bitcoin (or fraction thereof, such as a satoshi) is in reality just piece of computer code with special mathematical properties that prevent it from being counterfeited and that allow its bearer to add a certain number of entries to the distributed blockchain ledger maintained on computers all throughout the world. The bearer of one satoshi can sign the blockchain once. The bearer of one bitcoin, or 100 million satoshis, can sign it 100 million times. Without this magical code—that is, without at least a satoshi--adding to the ledger not only isn’t permitted, it’s essentially mathematically impossible.

Until the 21st million bitcoin is created, at which time “mining” (or the creation of new bitcoins) will stop, newly created (or “mined”) bitcoins are continually handed out by the network (in essentially a lottery) to those computers supporting the network.  Computers contributing more computing power (faster computers) to the network have a higher chance of winning the lottery than those contributing less.

The only other ways to obtain bitcoins, other than the mining “lottery”, is by gift; in trade for goods, services, or fiat currency; or by theft (if the current owner failed to lock down his/her bitcoins with a super-duper secret password).

We’ll discuss in a minute why having signing authority to add transactions to such a network has inherent value. But for now, it’s is important to note that the transfer of each satoshi (signing authority) from one party to another is itself recorded as a transaction in the distributed ledger (the blockchain). Hence, for me to transfer the right to make one entry into the ledger (that is, a satoshi) to you, I’d have to use up (or “spend”) one of my satoshis to do so. From that point forward, your “ownership” of that signing authority, that satoshi, is forever recorded on millions of synchronized computers throughout the bitcoin network, until such time as you might transfer it to another. Therefore, only you, or whoever else may steal this piece of code off of your computer (if you've not encrypted it strongly), can subsequently sign the ledger and transfer “your” satoshi, your signing authority, to another.  Fortunately the standard bitcoin client software now makes encrypting one's Bitcoin wallet easy.


Why Must I Spend Coins to Transfer Them?

Why must I give up some of my own signing authority in order to transfer signing authority to another? For lots of reasons, but mainly because this insures the scarcity of bitcoins. If I could transfer authority for you to sign the register without giving up some of my own authority, then bitcoins (that is, signing authority) would no longer be scarce. They could be duplicated (i.e., counterfeited).  Without scarcity, we cannot insure the mathematical integrity of the system. Without scarcity, people could input fraudulent transactions, or even spam, into the ledger. Without scarcity, transactions could be reversed, deleted, or otherwise corrupted. It’s just the way the math works. 


Signing Authority is Inherently Valuable 

So then, why is signing authority valuable? Merely because it is scarce? No! If that were the case, then critics of bitcoin, such as @TheStalwart, would be correct. Bitcoin would have no inherent value. It would be a very scarce but eventually worthless thing.

No, signing authority is valuable because it allows the person who has it to transfer information to anyone in the world (even if he/she doesn’t know who or where the recipient is!) nearly instantaneously, anonymously, completely securely, highly reliably, in a way that can’t be sprevented, intercepted, counterfeited, replicated, impounded, or censored, and (but for the cost of a satoshi) nearly for free.


The Extraordinary Implications 

The revolutionary implications of this are not readily apparent to those who have not spent much time contemplating it. Here are just a few (ranging from the mundane to the admittedly “far out”) applications of the bitcoin block chain:

First, the ledger can serve as a censorship proof public bulletin board.  Oppressed minorities can append information, or references to information in the blockchain.  The public an anonymously protest government actions.  In fact, Bitcoin's original inventor (who went by the hacker name "Satoshi Nakamoto" used Bitcoin specifically for this purpose by inserting a line of text into the first fifty bitcoins ever "mined".  The text reads "The Times 03/Jan/2009 Chancellor on brink of second bailout for banks", which is a reference to a Times of London article of said date.  Nakamoto was none too happy about governments robbing the poor to bailout the rich via mechanisms like bailouts and money printing, and wanted to "forever" lodge his protest in the blockchain ledger.

While its use as a protest vehicle may seem to be of trivial value, it doesn't have to be.   Note that one information is incorporated into the blockchain, it is there, in the public domain, forever (or at least as long as the Bitcoin network persists).  Censorship is now impossible.  DMCA takedown notices will become increasingly irrelevant and ineffectual.  Whether one agrees with Bitcoin being used in this way is irrelevant.  It has been and will be.  To deny that such use, however objectionable, has inherent value is to whistle through the graveyard.

But, it doesn't stop there.  The bitcoin ledger (or something very much like it) will almost certainly replace many of the services currently provided by notary publics. When a notary signs a document, he or she is essentially attesting that: (1) The document existed, (2) in a particular form, (3) at a particular time, and (4) was in a particular person’s possession and control. But, despite that we often require a notary’s attestation for certain important legal documents, these attestations are largely worthless. After all, I can have a notary sign the last page of a my parent’s Will tonight, only to subsequently “slip sheet” the third page of the Will without my parent’s or the notary’s knowledge tomorrow (so as to leave $100,000 to me instead of just $10,000). And, in fact, even if the notary had read the document before signing it, which they usually don’t, he/she would never be able to remember with unimpeachable certainty 15 or 20 years later exactly how much I was entitled to, and whether the version of the Will that I submitted to probate agreed to the one that she signed years before.

However, by making use of the distributed bitcoin blockchain, I can demonstrate with absolute certainty, and for all eternity (or at least as long as the blockchain is around), that a particular document in my possession today (for instance, a Will or a picture or a deed) is the exact document that existed on a particular specific date and time in history, all without revealing the contents of that document to the public or even revealing my identity at the time the documents was created! An overview of how this works can be found here.

The value of such a service, trivial though the service may sound at first, should not be underestimated. For instance, suppose that a hash of the original of everyone’s birth certificate were entered into the blockchain ledger immediately upon birth (either by one’s parents or even by the state). We could then forever prove with near absolute certainty where and when we were born should the need arise. How useful would it have been to President Obama and/or his “birther” critics if either could have demonstrated conclusively that a particular copy of his birth certificate existed in a particular form in August 1961 (when he was born)? Obviously, bitcoin wasn’t around back then, but future Presidents won’t be so unfortunate/fortunate.

The authority to add a transaction or piece of information to the blockchain makes it easy for authors, inventors, artists and others to prove that a certain work or invention existed in a specific form at a specific date in time, again without revealing the actual contents of the work or invention to the public. This could be useful in resolving patent disputes, copyright disputes, claims of origin or plagiarism, etc.

Many registrars of all types will be supplanted by the blockchain. For example, currently the Internet Corporation for Assigned Names and Numbers (ICANN) acts as a register and arbiter for ownership of domain names, IP addresses, etc. Bitcoin and related currencies offer of the possibility of a far fairer, cheaper, and censorship proof solution to domain name registration, and one that already has legs. But, it’s not just domain names. Bitcoin may eventually become a global distributed asset register. In fact, it provides the necessary infrastructure by which claims to most any good, service or commodity can be traded, even among strangers who don’t trust each other, on a peer-to-peer basis, without having to work through brokers, dealers or “trusted” intermediaries.

Where third party arbiters or trusted intermediaries are needed or desirable, such as with an escrow agent service, the Bitcoin system provides the infrastructure whereby the independent escrow agent can approve or reject a given transfer while physically being unable to use or abscond with the funds himself. Thus, the buyer/seller would be protected even in the event of the escrow agent’s bankruptcy. This is very different from traditional escrow services where theft or bankruptcy is at least a remote possibility.

And finally, Bitcoin represents an opportunity to safely enter into distributed contracts of all types, and even to create autonomous corporations, sometimes called distributed autonomous corporations  or DACs.


Where's the Beef? 

So, given all these potential uses, and more, how valuable is the right to add a transaction to the distributed bitcoin ledger powered by the world’s most powerful computer network? Well, even on the day of this writing, after a huge runup in bitcoin’s price, it’s surprisingly cheap. One Satoshi, the right to enter one transaction one time into the bitcoin ledger (the blockchain) is currently worth $320 (the current price of one bitcoin) divided by…wait for it…100 million satoshis per bitcoin. Or, said another way, one can currently purchase the right to add 3,125 transactions to the bitcoin ledger for a single penny.

Given its potential as described above, does that sound like a “bubble”? Regardless of your answer, it should be difficult for anyone who actually knows anything about Bitcoin at this point to argue, as so many have historically done, that bitcoins have “no inherent value”. The inalienable, irrepressible right to input a transaction into the world’s most powerful computer network, and by doing so to transfer censorship-proof information or virtual goods anonymously to anyone anywhere who has access to the Internet, is unquestionably useful, and like our magical shipping packages, will become even more so as more and more people learn how to make use of the service. With only a little more development, Bitcoin holds the potential to revolutionize entire industries (banking, shipping, notaries, registrars, trading and contracting, legal services, escrow services, auction services, and more).


So, is Bitcoin Money?

Well…no. Not yet. Though not for the reasons that so many often express (that is, a supposed lack of “inherent value”). Bitcoin isn’t yet money because simply because, at this stage of development, it is merely a store of value (and a volatile one at that). It is only just beginning to take on attributes of a medium of exchange (in the sense that, just within the last twelve months, it has become possible to purchase most any non-financial good or service with bitcoins if one tries hard enough), though its use as such is growing by orders of magnitude quarterly. It has a long way to go before it begins to function as a true unit of account, though given its continued exponential growth and network effects, that will happen far sooner than most suppose, likely within the next ten years (and maybe five). 

Baring the advent of a superior competitor that interrupts its current trajectory (which gets more and more difficult each passing day due to network effects), Bitcoin is poised to become good money for the same reasons that our hypothetical magical shipping packages became good money. For now, bitcoins are valuable because they are useful for certain special purposes. But, as exponentially more and more people learn how to use Bitcoin for these special purposes (that is, as more people learn the “magical incantations”), and as the number of purposes for which bitcoins can be used expands exponentially, demand will likewise rise exponentially. Given their limited supply, the law of supply and demand tells us that their price floor must also increase exponentially (baring their failure to work as advertised or being usurped by some newer technology).

A their price floor rises, more and more people are incentivized to learn how Bitcoin works. As more people learn to use them, demand grows even more. A great many online exchanges are already available to facilitate the trading of fiat currency into and out of bitcoins. As it becomes easier and easier to connect buyers and sellers of bitcoin (thanks to these global online exchanges), and as the user base increases, liquidity likewise increases. This has a stabilizing effect on price volatility, which increases its usefulness as a store of value and leads to even higher prices.

At this stage, savers and speculators have already entered the market. In fact, for the first few years if Bitcoin, they largely were the market.  People who have no current or even a likely future need to make many entries into the bitcoin blockchain nonetheless want to own the right to do so. They want to own bitcoins because they see that they are valuable to others and easily transferable, and will likely become more so over time.

This same rationale causes some who already own bitcoin to favor holding them over spending or selling them. With increasing demand and lower supply, prices increase even more so that the market can clear. The higher prices lead to more publicity and both incentivize even more people to learn how to use the service. Every new knowledgeable user exponentially increases the utility of the bitcoin ledger thanks to network effects.

Eventually, a few but growing number of businesses start accepting bitcoin as complete payment for goods and services. At first, many of those businesses quickly convert their bitcoins to fiat currency, since they don’t want to be exposed to exchange rate volatility and fiat is how they need to pay employees and suppliers. This constant selling of bitcoins by businesses serves as a damper on the constantly increasing, though still volatile, price.

However, as adoption and usefulness continues, businesses and individuals who refuse to learn to use Bitcoin find themselves at a competitive disadvantage. Even holdouts are this forced to learn about Bitcoin. As they do, the utility of bitcoin, and therefore its price, continues its exponential rise, fueled by network effects. Eventually, a tipping point is reached, more and more suppliers, and maybe even some employees, are willing to be paid in bitcoin. Those who can may even begin to demand it. 

Businesses who receive bitcoins as payment from customers are no longer forced to sell them so quickly (or at least not all of them) in order to pay suppliers and employees. Rather, they can now spend their bitcoins directly. The ability to spend bitcoins directly at wholesale, retail and consumer levels leads to their use as a full blown medium of exchange. It is increasingly unnecessary for businesses or individuals to go through the hassle, and endure the cost, of converting bitcoins to fiat currency and back (other than maybe to pay taxes).

Thus, bitcoins purchase ever greater amounts of goods or services, and their value, as priced in goods and services or fiat currency, continues their exponential rise, even more rapidly now since businesses are not selling them regularly to pay employees and suppliers. And finally, after five to ten years of their use as a medium of exchange, they eventually come to be used as a unit of account. Nearly all goods and services, worldwide, are priced in bitcoin in lieu of, or in addition to, fiat currency.


The Risks to Bitcoin 

Much could happen to prevent Bitcoin’s adoption as money in the manner that I have described above. For instance, perhaps its growth may be stunted due to its deflationary characteristics, and it will therefor serve only as a store of value (at best). This is a common argument often made by its detractors. But, I don’t find it persuasive for two important reasons.

The first is that deflationary characteristics haven’t proven to be an impediment to the development of currencies historically. For much of human history, “hard” money ruled the day. Ivory tower academics can debate whether a deflationary currency is sufficiently supportive of economic growth or not, but at an individual level, something tells me that people will choose to “own” hard money if given a choice. Wouldn’t you? For the first time in a long, long time, Bitcoin gives people that choice, and in the age of globalization, there's little that anyone, or anything, can do about it. Bitcoin may not be the "ideal" currency from the perspective of an ivory tower economist or central banker, but it's likely to be the preferred currency of the public nonetheless.

The second is that the ivory tower arguments against deflationary currencies, though appealing on the surface, are philosophically unsound anyway. Essentially, the argument against deflationary currencies is this:  If people expect that a given unit of the currency will purchase more in the future than it does today, people will hoard their money rather than spend it. In this manner, “bad money drives out good money”. The “good” money is hoarded while the “bad” money circulates and eventually becomes the only money.

But, this is flawed logic since the current price of a liquid and widely traded commodity obviously includes expectations of future price changes. As has been pointed out before, if a sufficient number of people expect the value of bitcoin to increase in the future, its value will increase today. How much will it increase? To whatever value is required for the market to “clear”. That is, to the point where enough hoarders will part with their bitcoins so that every potential buyer of a bitcoin can obtain one. That is, until there is a seller for every buyer.

At the time of this writing (which isn't necessarily the same as the date of this blog post), the price of a bitcoin, which includes discounted expectations of its future price increases (or decreases), is $320. This is the price at which enough “hoarders” are willing to part with their bitcoins in favor of fiat money. And, were they not so willing, then the price would go even higher (so long as buyers, which may even be other hoarders, are around). The key takeaways from this obvious premise are these: (1) the market will clear at some price (and sufficient hoarders will therefore part with the money today, thereby keeping it in circulation), and (2) anyone willing to part with a bitcoin for $320 in fiat currency is just as likely, and actually even more likely (for reasons that shouldn’t require too much thought but won’t be stated), to spend that same bitcoin on $320 worth of goods and services.

In short, the idea that bitcoin’s deflationary characteristics prevent it from being useful as real money (to purchase goods and services) is just silly. In a reasonably efficient market, that just can’t happen. 

So, in my humble opinion, Bitcoin is very likely to succeed as a medium of exchange. Thus, whether it ever becomes “money” or remains “just” a new type of commodity used in trade will depend very much upon whether it ever begins to function as a unit of account. Given that it is divisible to eight decimal places and is so easily transferable, I think it stands a fair change of jumping this final hurdle. But, even if not, it or something very much like it will almost certainly still succeed in other ways and disrupt innumerable industries, earning its holders a fortune along the way. Unless something superior comes along to disrupt that trajectory.  Soon.

While possible, the threat of a superior product is less and less likely with each passing day due to network effects. Even “antiquated” networks tend to retain their utility, and therefore their value, for long after a superior alternative comes along. For instance, were we to build the Internet from scratch today, we could certainly improve upon its TCP/IP infrastructure. But, we'll nonetheless be stuck with TCP/IP for some time due to network effects. 

Any of the above adverse scenarios, and many more, are entirely possible. But, if Bitcoin fails (as money or otherwise), it won’t be because it “lacks inherent value” or “governments will shut it down” or “people will hoard it”. Its inherent value is apparent for anyone with eyes to see. Its distributed, global nature makes it mostly impervious (even anti-fragile) to attacks from the establishment (including governments). And, since markets will clear, it won’t be hoarded into extinction either.


So...No Bubbles Then?

Well...no.  I don't mean to say that Bitcoin is somehow uniquely immune to bubbles.  It isn't.  It is very possible that its market value may, at any given moment, exceed its discounted inherent value by a considerable some, and that the two occasionally reconcile in a violent implosion.  So be it.  Great volatility hasn't dampened Bitcoin's growth or adoption to this point, and there is no reason to suppose that it will do so in the future.

Anyone holding bitcoins in the early stages of its growth must therefore be prepared for violent price swings, and those swings will likely continue until such time as fiat is readily converted into bitcoin and bitcoins are easily spent in commerce (without being converted to fiat money first).


 Conclusion 

Bitcoin has real inherent value--extremely subversive and disruptive inherent value.  It is also seemingly anti-fragile.  As a result, it stands an excellent chance of becoming “real” money. But, even if it fails to realize its potential as money, it may very well succeed as a new class of commodity, making its users wealthy in the process.