Bitcoin represents a new frontier in the creation of an economic and financial instrument.  It is open-source money, algorithmically created with a decentralized architecture.  Moreover, it functions as an economic means of exchange and a new investment asset class.  Its creation spawned other forms of digital-only sources of value, some which are open-source and others that are proprietary.  At times in U.S. history, various bank notes circulated as money.  We’ll see various forms of digital-only money circulating again.

Money History

Throughout monetary history, we’ve used different forms of money including seashells, feathers, gold, and silver.  Later we transitioned to representations that took the form of paper certificates.  These certificates were receipts to claim the precious metals they represented.  Society migrated towards precious metals since they were relatively scarce, durable, malleable, and required effort to obtain.

In the twentieth century governments severed the relationship between the certificates and represented metals. That severing permitted certificate creation without regard to precious metal relationship.  The certificates to which I refer are the paper money we call dollars.  Even fractional dollars (coins) decoupled from precious metals through the introduction of cheaper alloys for their minting.

Economies then progressed to digital money.  Digital money’s first iteration came with the advent of computerization.  This money still represented paper dollars, albeit in digital form.  This digital money was easily replicated, thus giving its issuer expanded powers to influence the economy and financial markets. 

Global Financial Crisis & Birth of Bitcoin

The Global Financial Crisis (GFC) of 2008, ignited by the increased financialization of the economy, brought further action by money issuers who minted trillions of dollars.  For critics, the money issuers responded to a crisis they fostered with the very thing that fostered the crisis — money creation.

If necessity is the mother of invention, the GFC provided ample necessity and inspiration. The result was a system of purely digital money created algorithmically and not at the whim of an issuer.  The abstract (1) from a white paper written under the pseudonym of Satoshi Nakamoto outlined the following:

“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work…”

Thus, was born Bitcoin (BTC), an open-source solution to the issue of unfettered money creation.  The biggest challenge in creating a new form of digital money was the issue of double spending.  Digital assets are easily replicated (think MP3, Word, Excel, PowerPoint files).  Creating digital money that anyone can copy and spend more than once would crater confidence.  BTC overcame the double-spend problem and, just as importantly, did it in a decentralized manner.  Moreover, BTC was conceived as purely digital money and not a digital representation of physical money.  It only exists in digital form.

Simply creating open-source money was but one step in a journey.  The money needed to establish itself in the economy and financial markets.  The first step was acceptance.

Bitcoin As Money

Let’s place Satoshi’s abstract under further scrutiny.  If BTC was to gain acceptance in the economy, it must behave like money.  Is BTC money?  Money should possess four important characteristics:

  1. Medium of exchange
  2. Unit of account
  3. Direct store or representation of value
  4. Fungible

Bitcoin has been a medium of exchange since its inception.  From a retail perspective, BTC certainly enjoys less exchangeability compared to a dollar though that is changing daily.  More people hold BTC and improvements like the Lightning Network have decreased transaction times.  BTC is exchangeable for goods and services. 

BTC operates as a unit of account since it’s measurable to small fractions of a Bitcoin unit, which not coincidentally are called Satoshis.  One hundred million Satoshis represent one Bitcoin.  This is significant divisibility.

BTC as a representation and store of value is a fascinating exercise.  In 2010, Florida resident Laszlo Hanyecz purchased two pizzas for 10,000 BTC (2).  Since the pizzas cost $20 each, the dollar value of the BTC exchanged was four tenths of one cent.  At the time of this writing, one BTC is exchanged for roughly $40,000.  Mr. Hanyecz could purchase 20,000,000 pizzas with the same amount of BTC today.  BTC stored value quite well and then some!  In case you’re wondering, they were Papa John’s pizzas. 

Fungibility is something not often considered in money’s definition.  Fungibility means one piece of money is just as good as another.  If I hand you a ten-dollar bill, I will gladly accept your ten-dollar bill in return, or two, five-dollar bills, or ten, one-dollar bills.  Bitcoin possesses the same characteristics — one BTC is just as good as another.

Since Bitcoin meets these four criteria, we can safely declare it money. If it functions as money, it can serve an important role in an economy.  The economic function is the most important of any new money form.

Bitcoin As Investment

If BTC is money, can it also be an investment?  Money offers no yield while an investment should, otherwise, there’d be no investing. An investment results from placing money in a risk asset and anticipating a return.  We don’t expect a return from holding a dollar bill.  We do expect a return if we invest that dollar bill in a stock or bond.

The investment perception of Bitcoin is based on its value relative to other currencies, or flag money — money issued by a sovereign nation. For example, the current exchange rate for the currency pair of BTC-US Dollar (USD) is roughly one BTC to 40,000 USD. Similar relationships exist between BTC and other currencies.

Currency pair trading is quite common.  For example, there are active markets trading pair combinations of USD, Euros, British Pounds, and Japanese Yen.  That trading is an expression of liquidity preference or which national currency you’d rather own at a moment in time. Currency pairs have a significant role in world commerce hence the robust market for their trades.  Liquidity preferences are also influenced by speculation.  Trading in the Forex (foreign exchange) markets dwarfs that of stock exchanges.

Bitcoin has other characteristics that could and should impact liquidity preferences. For example, unlike fiat currencies, its supply is algorithmically limited. Can you imagine central bankers placing a limit on national currency creation? That scarcity has deflationary implications signifying retained purchasing power over time.

Money on its own is not an investment.  Traded for other currencies, however, money can produce returns.  Currency trading has been around since the early 1970s.  Bitcoin is simply another trading pair for currencies like USD, Euros, Pounds, and Yen.  

While BTC experiences considerable volatility, its performance as an investment stands up well relative to any other asset class.

Summary

Bitcoin represents a new frontier in the creation of an economic and financial instrument.  It is open-source money, algorithmically created with a decentralized architecture.  Moreover, it functions as an economic means of exchange and a new investment asset class.  Its creation spawned other forms of digital-only sources of value, some which are open-source and others that are proprietary.  At times in U.S. history, various bank notes circulated as money.  We’ll see various forms of digital-only money circulating again. 

 

Other content from articles published by Jim Mosquera in Seeking Alpha, a financial market publication.