How Crypto Crosses the Moat
How could Bitcoin and Ethereum have value as assets & currency in the first place?
Disclaimer: I am not a financial service professional. This is not financial advice and is for informational purposes only. Do your own research. I hold positions in some of the assets mentioned.
For those unfamiliar with the crypto space, there is a moat.
There’s this thing called Bitcoin (BTC) that claims to have value. These days, lots of people seem convinced that it’s really valuable—it’s hovered around a $1 trillion market capitalization for several weeks and it’s risen dozens or hundreds of times more quickly year-over-year than any other investment vehicle. Every few years, when its value prominently spikes, national financial news sources take notice and discuss Bitcoin-the-speculative-asset doing really well and pontificating about how high it might go or when it might crash. In this way, it is discussed like a stock.
But financial news media hasn’t adequately explained why it has value in the first place. There is no company underlying this asset, nor a tangible substance like gold; indeed, it’s easy to get the vibe that institutions are perplexed by the whole thing and think it doesn’t have value. I can’t source this, but I’ve heard privately from a friend at an investment bank that most of his colleagues passed over BTC or thought it was pointless, and its spike in value throughout Q1 2021 has caused pandemonium in the industry as everyone scrambles to figure out why this is happening and how to take part.
Up to now, though, almost all BTC investment has been from retail investors—individuals investing personal funds—as opposed to institutional investors such as banks and hedge funds. I think the crypto-holding demographic has done as much outreach as it reasonably can, but it’s hard to make a case for why it has value when most of the media has spent so long discussing how unstable it is and arguing against its existence. For those who did invest around January 2018, during the most significant spike in value (and popularity) before the current one, the subsequent crash left a sour aftertaste and limited the appeal of the investment for a few years.
But here we are in the midst of a strong market and people are evangelizing about crypto again. For my part, I just accepted a full-time job offer in the crypto space two weeks ago, which has put me in the position to field questions from my friends, family and colleagues about the space.
The most frequent question is how crypto has any value at all. Most people accept the reality that BTC is trading for over $50,000 each, which is a crazy high amount of value for something worth next-to-nothing ten years ago—it’s just not clear to many people where that value is coming from.
Below I explain the economic case for Bitcoin’s value, and then we’ll get into the value of the lesser-known-to-the-mainstream (but much more interesting) Ethereum. Let’s get into it.
Crypto has value by fiat
Currency is three things:
A store of value—if I have $1 today and can use it to buy a soda, I want it to still be worth one soda tomorrow;
A medium of exchange—I should be able to buy a wide variety of goods by using dollars rather than having to convert them into something else first; and
A unit of account—it should be used to denominate the value of other things, e.g. it should be coherent and useful to say “this item is worth five dollars.”
Historically, some currencies were placed on a standard, which means you could go to a bank and redeem that currency for something of value (typically gold). As society grew and economics became more sophisticated, all major currencies switched to a fiat model: the US dollar has value because the US government says it does and, more critically, other people agree that it does. It doesn’t matter that there is no underlying asset if there is consensus among the population that it is valid currency.1
We are in a place where we all rely on fiat currencies every day to live our lives. Conceptually, Bitcoin is similar: it has value because a large portion of society agrees that it has value. To put it more concretely, 1 BTC is worth over $50,000 because there is a market where someone is willing to buy it for over $50,000.2
In the early days of Bitcoin, this was a weaker argument because it was much less well-known, initially had zero merchants willing to accept it, and was worth pennies even between people who knew about it. Now, there’s widespread agreement all across the world that it has value, so it does.
Crypto has value by design
Cryptocurrencies would be useless if they weren’t designed according to economic principles. To avoid going too deep into implementation details, what’s important to understand is that it’s hard to create new Bitcoins: over time, new BTC is increasingly hard to mint. This is because computers have to solve increasingly difficult math problems for the privilege of minting new bitcoins, so there is a computational guarantee of scarcity.
Consider this hypothetical: tomorrow, a massive gold mine is uncovered just outside San Diego. It’s easily and quickly mined. It has more gold than has ever been discovered before—indeed, it has ten times more gold than the current global circulating supply, so now there’s a total of eleven times more gold than before. The supply of gold skyrockets and demand stays roughly the same, so the price of gold plummets.
This is computationally guaranteed not to happen with Bitcoin. Suddenly, having your store of value reside in the real world doesn’t look so good!
This is one innovation of cryptocurrency: the concept of computationally guaranteed monetary policy. The mechanics of bitcoin's supply are known and agreed upon by its community—there’s no central bank that can decide to print $2 trillion of BTC tomorrow. In this way it is a highly predictable store of value—or, rather, it would be if not for the huge amount of speculative investment which regularly drives enormous changes in its price!
Other aspects of its design provide useful guarantees that allow bitcoin to mimic the characteristics of a real-world asset. The most important of these is a guarantee against double-spending. It isn’t possible to edit your BTC balance up or down arbitrarily, nor spend the same BTC twice: according to the protocol which governs the system, all BTC must either be mined (meaning a computer solves a difficult math problem and is rewarded with some newly-minted BTC, as discussed above) or be transferred from someone else. Thus there is no funny business: there is a network of bitcoin miners constantly validating other network members' behavior. Collectively, this network mines blocks which make up the blockchain.3
Because BTC is a relatively young concept (first implemented in 2009), and because it’s an exciting new technology with an ever-larger community supporting it, it’s also performed really well as a speculative asset. This drives further popularity, garnering further hype, and so on in a vicious cycle. Irrespective of all this, it offers a valid alternative to investing in gold.
Ethereum has obvious concrete value
Now we get to Ethereum (ETH). At present, the Ethereum network works pretty much the same way as Bitcoin does, but with added features.
I quickly discussed how Bitcoin operates on a network of miners, who perform computational work to record historical transactions between holders of BTC. There is only one basic type of transaction: a transfer of BTC from one address to another.
Ethereum asks the question: what if you could perform any computation you wanted inside a block, not just a transfer of value?
While the details are technically complicated, this is what Ethereum enables. It is possible to deploy code to the Ethereum network, and anyone can run that code. The code is guaranteed to execute exactly as written and thousands of computers verify the result. This code is called a smart contract.
The classic example of a smart contract uses the analogy of a vending machine. A vending machine is a physical implementation of a simple contract:
If you put money in, the machine gives you something.
If you don’t put money in, the machine doesn’t give you something.
And the corollaries:
If you put money in and don’t get something out, that’s bad.
If you don’t put money in but you get something out, that’s bad.
So a smart contract on the Ethereum blockchain may encode an agreement like: “If you give me 2 ETH now, I will invest it somewhere and you’ll be able to withdraw 2.5 ETH in a year,” or “If you give me 0.2 ETH, I will give you a digital representation of a cat,” or “if you give me 200 ETH, I will give you a token that you can later redeem for a certain percentage of the rental income from a commercial property in Manhattan.” Versions of each of these already exist.
It helps, too, that the Ethereum network supports different types of tokens. There is ETH itself, and there are also tokens like USDC, which is always worth exactly $1 on the market. All of these can be transacted and stored on the Ethereum network. Many different tokens enable diverse, interesting projects to run on the platform, ranging from automated lending markets to decentralized asset exchanges. Many of these engage with crypto-assets, and many also use tokens representing real dollars. There is an entire vibrant economy forming in the Ethereum network, all based on the underlying value proposition of Ethereum: if you pay Ethereum to the network, it is guaranteed to perform whatever computational work you tell it to.
Just like Bitcoin, Ethereum is decentralized, trustless, and comes with robust security guarantees. In this way, Ethereum’s value proposition builds on that of Bitcoin and is much more apparent. You don’t need to rely on an understanding of economics or fiat currencies to understand Ethereum’s value proposition because it comes in the form of actual computational work.
Of course, ETH is also a speculative asset and intends to be a currency. Right now, the price of most common cryptocurrencies, including ETH, correlates closely with the price of BTC due to speculative activity, so it’s hard to know exactly where the price of ETH would land (or how stable it would be) without this effect. To sidestep this, the Ethereum network also supports much more stable stores of value in the form of “stablecoins” like USDC, as discussed above. As it happens, I have most of my cash savings in such a form on the Ethereum network.
Enthusiasts like myself generally expect crypto to be increasingly relevant to broader society over time. I’m certainly among them. I hope this piece has helped “cross the moat,” so to speak, between the worlds of crypto and regular currency.
I’m much more excited about Ethereum than Bitcoin, in large part because it has a more concrete value proposition and, in my opinion, a more forward-thinking community philosophy for executing on the potential of blockchains. But Bitcoin and Ethereum are not attempting to be the same thing. Bitcoin is “digital gold” and executes on that vision very well. By contrast, Ethereum could be summarized as a general-purpose blockchain—a “world computer” of sorts which other applications are built on top of.
Both are likely to have enduring economic value measurable in ordinary currencies for the foreseeable future.
At times, fiat currencies have been mismanaged and lost the faith of the people. One recent example is hyperinflation in Zimbabwe, where the Zimbabwe dollar lost value so quickly & consistently that it became useless as a currency.
It’s also helpful that increasingly many major merchants and payment processors are willing to accept bitcoin as payment for goods and services, from PayPal to Tesla.
A block is a batch of transactions between bitcoin holders, recording the activity of the network. You write a block to the blockchain by solving a computationally difficult math problem. Whoever solves this problem first and presents a valid solution to other miners is rewarded with newly-minted BTC. In this way, the blockchain is a public ledger of all transactions that have ever happened.