What Makes Bitcoin Innovative?

What Makes Bitcoin Innovative?

Bitcoin may seem boring to some people, outdated to others, or even referred to as “boomer” coin. However, people that make those comments show a lack of understanding of what is really innovative about the invention, Bitcoin. The purpose of this note is to drill down to what is actually innovative about Bitcoin. The innovation of Bitcoin is not intuitive, but in reality is quite profound. 

An Asset that can’t be Corrupted or Changed by Humans

Bitcoin is the first man made “thing” that can’t be modified, altered, or otherwise ruined by humans. No person or group of people has the ability to make changes to the core properties of Bitcoin. Since nobody can gain control over the Bitcoin network; it remains a neutral asset and universally desirable. Bitcoin was designed that way since inception, as stated by anonymous Bitcoin inventor, Satoshi Nakamoto:

“The nature of Bitcoin is such that once version 0.1 was released, the core design was set in stone for the rest of its lifetime.” –Satoshi Nakamoto, BitcoinTalk.com, 2010 

Gold can be used as an example of what a neutral asset can be. The properties of gold (density, color, max supply, etc.) can’t be changed by any group of humans no matter how influential or wealthy they are. If, hypothetically, the max supply of gold could be modified by say, China, then gold would become less desirable to hold anywhere else in the world. No reasonable person would have trust in holding gold if a group of outside people have the power to change any of gold’s basic properties. 

An asset that is impossible to change is an asset that can be trusted and universally desired. This innovation is counter-intuitive to most people; especially people who are used to modern software platforms that receive regular updates. Bitcoin should be thought of as a sturdy foundation for which to build a stable economic system. It is built to store and transfer value; nothing else. Since Bitcoin is natively digital and programmable, applications can be built on top of this Bitcoin base layer to fulfill more complex needs.

What makes it impossible to change the properties of Bitcoin? The answer lies in its distributed topology. It is estimated that there are over 100,000 Bitcoin nodes in operation around the world. Nodes are computers that run the Bitcoin software which encodes the properties of Bitcoin. In other words, the nodes enforce the rules that determine Bitcoin’s properties. Bitcoin node operators have a strong incentive to keep the protocol running as is, and in a manner that serves their own best interests.

Image: Bitcoin Nodes around the world, source bitnodes.io

Two of the core properties of Bitcoin are the 21 million coin supply cap, and 1MB block size limit. There are many self interested people who desire to change these properties, but the resilience of the Bitcoin network makes it practically impossible to change them. 

For illustration, say a group of people wanted to change Bitcoin’s 21 million supply cap; and increase the limit to 42 million coins. They would start by changing the code of the Bitcoin software to reflect a 42 million supply cap. After all, the software is open source and anybody is free to make changes to the code as they desire. The hard part is in convincing a majority of Bitcoin node operators to update the software on their computer to this new 42 million coin version. A version of software which goes against the node operator’s own self interests. If the group fails to convince a majority of node operators to upgrade their 42 million coin supply version of Bitcoin, then all that they have done is create a minority hard fork version of Bitcoin. A version of Bitcoin that is not compatible with all software applications and businesses which have already integrated with the original version of Bitcoin, as well as has a significantly weaker mining and node infrastructure; the infrastructure which provides security for the network. The group, in its attempt to change Bitcoin to a 42 million coin version, just alienated itself with a version of Bitcoin that practically nobody uses or trusts.

This theory has been put to test in the real world many times; but most notably in 2017 when there was infighting within the Bitcoin community about whether to increase Bitcoin’s 1MB block size, to a 2MB block size. The change of the block size limit was controversial because an increase in block size would have possibly reduced the level of decentralization of the Bitcoin network.

The block size limit determines the data storage requirements of Bitcoin’s blockchain from each node operator. Every 10 minutes in the Bitcoin network, a block of data which contains recent Bitcoin transactions is added to the blockchain. If the size (measured in MB) of each of these blocks is increased, it will increase the size of the blockchain data, and corresponding computer hard drive requirement. Since each node stores a copy of the blockchain, a higher storage requirement for the blockchain means that fewer people have the financial resources required to purchase the node hardware. The fewer people that have the financial means to run node hardware, means that fewer nodes will be in operation, and the network becomes less decentralized. Decentralization is a key innovation of the Bitcoin network. Sacrificing decentralization is sacrificing part of what makes Bitcoin innovative.

At the time of the infighting in 2017, 95% of Bitcoin miners signaled support for the switch from a 1MB to a 2MB block size limit. The block size increase would theoretically increase the transaction throughput of the Bitcoin network and reduce transaction fees. The Bitcoin miners (or any other group) however, do not have the power to change any of Bitcoins properties, the node operators do; and they “vote” by updating their software. Most node operators refused to make the change to the 2MB version of Bitcoin. What resulted was a hard fork of the Bitcoin network. A new version of Bitcoin was created; Bitcoin Cash, which had a 2MB block size. The miners did not succeed in making their proposed change to Bitcoin, but instead alienated themselves by supporting the Bitcoin Cash network, something that is different from the original Bitcoin. 

The Bitcoin network software developers were forced to pursue other scaling methods that did not sacrifice decentralization. Bitcoin Cash has since slowly faded into irrelevance with network usage that is trending toward 0, and price that has crashed sharply compared to Bitcoin. Bitcoin Cash price denominated in Bitcoin is shown below. Bitcoin Cash reached a peak of being worth 0.25 of a Bitcoin in late 2017 and has since bled value relative to the original Bitcoin only being worth 0.006 of a Bitcoin today. 

Bitcoin cash, like many other hard forks of Bitcoin are examples of failed attempts to make changes to Bitcoin’s core properties. 

Stable Monetary Policy is Innovative

The central bank of the United States, the Federal Reserve, is a group of unelected officials who have two superpowers that nobody else on the planet has: the power to print money out of thin air, and the power to control the price of money (interest rates). These two superpowers combined are what is referred to as monetary policy. Using their tools of monetary policy, the Fed pursues three stated objectives: maximum employment, stable prices, and moderate long-term interest rates in the US economy. While the intentions of the Fed may be noble, the outcome of their policies are anything but. 

In the most optimistic view, the Fed makes decisions that are in the best interests of the United States as a whole, as well as all holders of the United States Dollar (USD), and USD denominated debt. However the Fed is just made up of humans. Humans that can make mistakes, become corrupted, or become self serving. Decisions that the Fed makes are decided behind closed doors and in an opaque manner. The people that are actually affected by their monetary policy are left clueless about what the next move of the Fed will be. Fed decisions affect the value of the money that we all use; the money that is the world’s reserve currency. 

Any person that actively participates in markets is a victim of the Fed. Fed policy has a huge effect on the price of investment assets that everybody holds. Investors cannot only focus on the fundamentals of the business or asset they want to invest in; they must now also be Fed watchers; carefully parsing out every word that Fed Chair Jerome Powell says at any public speaking event, to gain an edge, and predict what the Fed might do next with interest rate policy. The words out of Jerome Powell’s mouth at a press conference, might crush or make the price of your investment rise significantly, depending on if his tone is bearish or bullish. Fed monetary policy decisions create huge swings in debt and equity markets. For example in 2022 in the equity markets, the average daily change of NASDAQ on a normal trading day (day’s without an FOMC press conference) was 1.6%; while it was 2.6% in the day after the FOMC announced their updated monetary policy. 

In recent decades, unreliable Fed policy has been the main driver of bubbles in financial assets. Debt bubbles are fueled by low interest rate policy from the Fed. Low interest rates cause people to take on more debt than is sensible, and for reasons that are not justifiable.  One key indicator of a bubble in equity markets is the amount of margin balance in consumer brokerage accounts. The chart below shows the US Brokerage account margin balance plotted against the fed Funds rate (interest rate determined by the Fed).

In the chart above it can be seen that 0% (or near 0%) interest rate policy has a direct effect on the amount of leverage investors take in their brokerage account through margin debt. The Fed is in the driver’s seat when it comes to creating and destroying asset price bubbles. They push the accelerator pedal to the floor with 0% rates, create an asset bubble, then pop the same bubble that they just created by slamming the on the brake pedal by increasing interest rates.

The Fed Policy has been anything but stable. In the chart above, the fed funds effective rate(red line) looks random and erratic; that’s because it is. The Fed funds rate is a key signal that all market participants rely on to make economic calculations. Our government, foreign governments, home buyers, car buyers, businesses, all users of money and debt; basically everybody, is impacted by the decisions that the Fed makes. People need price stability and reliable interest rate policy for operating and planning purposes. 

The monetary policy put into place by the Fed is a stark contrast to the programmatically controlled monetary policy of Bitcoin. 

The monetary policy of Bitcoin is simple: A strictly limited supply of Bitcoin units that is capped at 21 million Bitcoins. New Bitcoins are issued every 10 minutes and received by the Bitcoin miners when a new block is mined. This compensation that the miners receive is also known as the miner reward. The amount of coins received in the miner reward started at 50 coins per block in 2009 when Bitcoin was launched, and decreases in half roughly every 4 years (every 52,000 blocks). The current reward is 6.25 Bitcoin. That is, 6.25 Bitcoin that miners receive as a reward every 10 minutes. The stable monetary policy of Bitcoin is graphed below.

The monetary policy of Bitcoin is completely predictable and reliable. Plus, the entire supply of Bitcoin is auditable by any person who chooses to run the Bitcoin software on their computer. The system is completely transparent in that way. By plotting the monetary supply of Bitcoin on a chart like above we can determine what the supply and inflation rate of inflation has been at any time in the past, what it is presently, as well as estimate what it will be at any time in the future. After Bitcoin becomes more mainstream, I suspect we will look back at the current systems of determining monetary policy like:

A Perfect Savings Account (Store of Value)

Traditional money issued by the government is a poor store of value. The problem with government money(also known as fiat money) is that it is issued by a single entity; a central bank; or more specifically the Federal Reserve(The “Fed”) in the US. The Fed has the ability to print new units of USD at their discretion; and are the only group of people with permission to print the currency.  Since the Fed has the power to print money, they are always incentivized to do so. When additional dollars are printed, it increases the overall supply of dollars. With an increased supply of dollars in the economy chasing a fixed supply of goods and services, the value of the dollar declines in terms of purchasing power. In the chart below, it can be seen that the US dollar has lost about 97% of its purchasing power since 1913, the year that the Fed was created. 

Shown above is the declining purchasing power of the current world reserve currency but this is just one example. In fact, there are no examples of government currency that have stood the test of time. Of the roughly 750 currencies that have existed since 1700, only 20 percent remain, and all of them have been devalued. 

Since 1971, when Nixon went off the gold standard, the US dollar is no longer redeemable for gold. Without a scarce asset backing the USD, the Fed can print virtually limitless amounts of new currency units. Abuse of this power means that government issued money will almost always decline in purchasing power over time, as central banks issue new units of the currency. This point can be made clearer in the words of Saifdean Ammous:

“For as long as the money was controlled by anyone other than the owner, whoever controlled it would always face too strong an incentive to pilfer the value of the money through inflation or confiscation, and to use it as a political tool to achieve their political goals at the expense of the holders” – Saifedean Ammous, The Bitcoin Standard

Governments face a strong incentive to print additional units of the currency as a short term as a “fix” to almost any problem a nation may face. Governments print money out of thin air to “stimulate” the economy, pay for entitlement programs, and fund never ending wars; despite the fact that they do not make enough income through taxation to fund these programs. Governments will almost always choose to bridge the gap in deficit by printing additional currency units, instead of cutting government programs that voters care about like social security, or defense.

Unlike fiat money issued by the government, Bitcoin has an actual cost to production. That production cost is the cost of electricity that miners incur. The miners must consume this real world resource, or else they will not get the reward of new Bitcoin. Nobody can create new units for free. To top it off, the 21 million coin supply cap of Bitcoin can’t be changed. No people can create new units and devalue Bitcoin no matter how hard they try.

Since holding savings in government currency is a guaranteed losing bet, people demand to hold their savings in assets where they can preserve or increase purchasing power over time. These assets are used to protect people’s savings from inflationary fiat money or an uncertain economic outlook. The typical asset that comes to mind in the context of Bitcoin is gold. The scope of store of value can however be extended beyond gold to include; collectible art, bonds, and real estate. These are all assets that people store wealth for protection against inflation, and preserve their savings.

Compared to all of these assets, the properties of Bitcoin make it the best asset to hold as a store of value.

Scarcity: Can more of the asset be made easily diluting its value?

Perfect digital scarcity is the breakthrough invention of Bitcoin. Never before in history has a resource existed that was truly limited in supply. Even a rare metal like gold is not truly limited in supply as around 2% of new stockpiles are mined and added to the total gold supply every year. Bitcoin is strictly limited to 21 million coins mined by the year 2140. No new coins can be created beyond that point. 

The supply of Bitcoin increases in a reliable, programmatically controlled way. As the price of Bitcoin increases, no additional Bitcoin can be produced by the miners to keep up with increased demand. This is unlike an asset like gold, whose supply increases as a response to increased price. Since no additional Bitcoin can be produced in response to price increases, Bitcoin is the first true perfect store of value by creating an asset that is truly limited in its supply. 

Liquidity: How rapidly can the asset be exchanged for money or another asset?

Bitcoin can be exchanged for USD or native currency within minutes in a global market that is open 24/7 and 365 days a year. In addition, Bitcoin is highly fungible and can be exchanged directly for goods at any time. 

Durability: Can the asset be destroyed, tarnished, or degraded over time?

Bitcoin exists only in digital form and is “stored” in a decentralized way on the blockchain. Bitcoin can’t be degraded, damaged, or tarnished over time. Unlike an asset like real estate, there is no ongoing maintenance cost, taxes, or insurance required to hold Bitcoin.

Portability: How easy is it to move and store the asset?

Bitcoin is “stored” publicly on a decentralized public ledger(the blockchain) network. A person can access their funds anywhere on earth as long as they possess the private key(a random string of characters) to unlock the funds, and an internet connection. Also because Bitcoin is purely digital, the physical size of Bitcoin does not increase as more is accumulated. Meaning whether a person has a million dollars of Bitcoin or one dollar of Bitcoin, the physical size of your money does not change. Unlike a physical asset such as gold where the more that you accumulate, the more you are burdened with physical gold that must be carried around.

Security: Can a person be sure their money will still be there the next day?

The Bitcoin network is the most secure network in existence and has never been hacked to date. The network is antifragile, meaning the more that it is attacked, the more resistant it becomes to attack. The economic resources required to hack the network are virtually impossible for any person(s), or nation state to acquire at this point.

Utility: Does the asset actually provide a useful function for a person?

Bitcoin is highly fungible and can be used as a medium of exchange. It can be exchanged for virtually limitless amounts of goods. It ranks slightly lower here however because its usefulness as a medium of exchange is tampered with by the tax law in the United States; where each time Bitcoin is used to purchase something it is a taxable event. 

Censorship Resistant: Can the asset be seized, or frozen by an outside group? Bitcoin can be held in self custody on a simple hardware device, or even by memorizing a 12 word phrase. No trusted third party like a bank is required to hold Bitcoin. No group of people have the power to freeze or seize Bitcoin that a person holds in self custody.