The Promise of Bitcoin
Hello investors, and welcome to my substack where I study value investors and great businesses.
Today, we'll be taking a look at the book “The promise of bitcoin”. Before we start, as value investors, we idolize Charlie Munger and he has said:
“I hate the Bitcoin success ... I don't welcome a currency that's so useful to kidnappers and extortionists and so forth, nor do I like just shuffling out of your extra billions of billions of dollars to somebody who just invented a new financial product out of thin air... I think I should say modestly that the whole damn development is disgusting and contrary to the interests of civilization... It's really kind of an artificial substitute for gold. And since I never buy any gold, I never buy any Bitcoin.”
Let's take a closer look at that quote because it contains a lot of information. Bitcoin does not appeal to Charlie Munger. c. Because Bitcoin is almost completely untraceable, it is widely used by criminals, but the same argument could be made for cash. The second point is that a brand-new financial product appeared out of nowhere. In some ways, this is correct. It began with nothing and now has extensive documentation, a large following, a massive computer network, and a long adoption period that is just getting started. Because of Bitcoin's speculative nature, his third point about Bitcoin being against the interests of civilization is correct. Bitcoin, unlike a stock that represents a piece of a tangible company whose value can be easily derived from the money it generates, has no backing. Its value is determined by its scarcity as well as the blockchain and decentralized technology used to create it. His final point is a continuation of this: why would he invest in the "new gold" if he doesn't invest in gold? This investment, however, is not for him. Nonetheless, for many people interested in investing in gold or diversifying their portfolio, Bitcoin is a viable option.
But as Charlie Munger also says - “Invert. Always invert” - so in that light, i’ll cover why it might be a good idea to buy into bitcoin given charlie munger’s thoughts at the back of my mind.
To begin, I find StopSaving.com's graph to be instructive. It suggests that adding a 5% stake in Bitcoin to an S&P 500 portfolio would result in significantly higher annual returns. Of course, past performance does not guarantee future results.
So given this, let's dive into the book - “The Promise of Bitcoin”.
Chances are, you’ve heard of cryptocurrencies – the digital alternatives to dollars and euros that have been making headlines for around a decade now. In that time, their total market value went from zero to over $1 trillion. So what’s behind their rapid rise?
It’s simple: they offer something conventional currencies don’t. They’re more transparent and democratic, for starters. They also give you unprecedented freedom to spend, invest, and buy as you please. Most importantly, they’re not controlled by governments or central banks.
As you’ll see, all of that’s especially true of the original and perhaps still most famous cryptocurrency: Bitcoin.
What is Money?
Bitcoin is a digital currency. So, unlike dollars, euros, or yen, bitcoins don’t take the form of physical coins or bills. Instead, each one is an encrypted set of numbers – hence the term “cryptocurrency.”
In other words, it’s money unlike any other in history. But when you get down to it, pretty much anything can be money. You can use beads, shells, spices, salt, silver, or gold. It’s not the particular thing you’re using as currency that really matters, but the fact that people use it. Widespread adoption is what gives it legitimacy.
In the language of economists, money is a medium of exchange, and by most measures, it’s a pretty good one – as long as it’s in the right hands.
Money isn’t the only way to exchange goods. There’s also bartering, or directly trading something like apples for boots. This system works, but it’s inefficient: if your shoemaker doesn’t need fruit, he won’t mend your footwear.
Bartering has been around for a long time. Over 3,500 years ago, Phoenicians and Babylonians created a vast barter system that extended from the shores of the Mediterranean to the banks of the Euphrates. They traded weapons, spices, and luxury goods. Centuries later, the Romans – who conquered much of this territory – used scarce and highly valued commodities like salt to pay their soldiers.
Goods-based barter continued for millennia. Even societies with complex monetary systems returned to barter at times. During the Great Depression in the United States, for example, cash-poor Americans exchanged goods like corn for medical services or coal to heat their homes.
Barter might not be the most efficient means of connecting buyers and sellers, but it does have one great merit: it’s self-governing. That means, the users of the system establish the value of their “currency.”
Money issued and backed by states is different. Take the sixth-century kingdom of Lydia. This state, located in today’s Turkey, is credited with creating the first centralized currency. The monarchy determined how much this currency was worth and guaranteed its value by imprinting regal symbols like eagles on its coins.
Commerce flourished – initially. The problem the Lydians introduced, and which every centralized monetary system since has also confronted, is that the power to guarantee a currency’s value has a flipside. It also means you can devalue it.
Money is a medium of exchange, but that’s just one of its facets. Economists also identify a second feature: it’s a store of value, meaning it retains its value over time.
The History of Money
Look back over monetary history, and you’ll see that this second trait is more common in theory than in practice. In reality, the value of money usually tends to shift. One solution to this problem is to centralize control over money, which gives governments and banks the power to influence its value.
Unfortunately, those governments and banks often abuse that power. The result? The currencies they control become less and less valuable.
If a government is short on cash but controls the money supply, it can simply smelt new coins or print new bills. This drives inflation, which is an increase in prices and a fall in purchasing power. The more cash there is sloshing around the economy, the lower the value of that currency – so you need more of it to purchase goods.
In small amounts, inflation isn’t all bad. If people notice prices are rising, they often decide to buy big things like cars today rather than wait until tomorrow, when they’ll be even more expensive. This can boost the economy. Too much inflation, however, wipes out savings and reduces investment. Households have less cash to spend, and the yield on investments is too low to be worth the risk - this results in stagnation.
That’s exactly what happened in fifteenth-century China – the first country to introduce paper banknotes. Whenever the government needed cash, it printed new bills. Soon, its currency was so devalued – notes were worth just 0.014 percent of their face value that it had to abandon paper money.
Banks can also expand the money supply by extending credit, loans, and mortgages; this policy can do as much harm as governments printing money.
For example, the Great Depression was largely caused by banks lending more money than they had on hand. When the stock market crashed, anxious depositors tried to withdraw their savings. This led to a bank run –
One-dollar bills and two-euro coins have no intrinsic value. One is a cheap piece of paper, and the other is a copper and zinc alloy worth a few cents.
Clearly, the value of dollars and euros isn’t related to what they’re made out of. Nor is it linked to commodities like precious metals. This makes these currencies examples of fiat money. That term comes from the Latin word for “decree,” which is pretty much how they come by their value: states declare that one-dollar bills and two-euro coins are legal tender.
Fiat money is free-floating – nothing anchors its value except trust in the state issuing it. But what if you don’t trust those states? That, in a nutshell, is the question which Bitcoin seeks to answer.
Fiat money is an effective means of exchange. Take the US dollar, the “global reserve currency.” Governments around the world keep dollars on hand for international transactions like buying and selling oil. That means you can use the dollar pretty much anywhere in the world.
It’s not great at retaining its value, though. In 1979, you could buy two pairs of top-of-the-line Nike sneakers with a $100 bill. Today, a single pair costs more than that. In another decade, it’s likely that a hundred dollars won’t even buy you a pair of Nike shower sandals.
The era of fiat money, and rapidly decreasing purchasing power, began in 1971. After the Second World War, important global currencies like pounds and franks were tied to the US dollar, whose value was in turn linked to the gold standard – that is, the international price of gold. This effectively bound the hands of governments. Because anyone could redeem their dollars for gold, governments could only print as much money as they actually held in gold.
By the late ’60s, though, the United States was in economic trouble. It was bogged down in an expensive war in Vietnam and facing trade deficits at home. Its gold reserves, meanwhile, were being depleted by foreign governments cashing in dollars for gold. So in 1971, it abandoned the gold standard.
Since then, governments and central banks have had a free hand to print cash – a policy which has become a frequently used all-purpose cure for economic crises. For critics of this approach, the cure is worse than the disease. So what’s their alternative? Simply put, to reinvent the gold standard for the digital age. Enter Bitcoin.
So what is Bitcoin? Technically speaking, it’s virtual currency or cryptocurrency – that is, a payment system which uses digital “coins” that are encrypted to be fraud-proof.
Bitcoin isn’t just about technology, though. At a deeper level, it’s a solution to the problems associated with centralization and fiat currencies that we looked at earlier.
The problem with these monetary systems, critics claim, is that they require us to trust institutions which have shown themselves to be untrustworthy. But what if you could delegate decision-making powers to a kind of calculating machine which simply can’t make bad decisions? That’s just what Bitcoin promises.
On January 3, 2009, Satoshi Nakamoto unveiled his solution to the problem of trust and the abuse of fiat currencies – Bitcoin.
Nakamoto claimed to be a 32-year-old Japanese coder, but many believe that he was actually Yasutaka Nakamoto, a former courier for the Colombian drug kingpin Pablo Escobar. Others, like Bobby C. Lee, the author of the book, suspects a three-person team of Australian coders.
Whatever Nakamoto’s real identity was, one thing was clear: Bitcoin was a definitive advance on earlier designs for digital currencies.
Why?
Well, all digital currencies have to contend with the double-spending problem. Spend a dollar in cash and it’s gone – two people can’t simultaneously spend the same dollar. You can counterfeit currency, but that’s pretty hard. Compared to the difficulty of forging state-of-the-art government-printed bills, copying and spending money online is as easy as hitting “control” and “c.”
The standard solution to this problem is to entrust recordkeeping to large, centralized institutions like banks, which verify and record transactions. Satoshi, however, had just watched banks crash the global economy in 2008, so that was the last thing he wanted to do. That’s where blockchain comes in.
Blockchain is essentially a spreadsheet that solves the double-spending problem without involving large institutions. In Bitcoinese, it’s called a distributed ledger. It’s a bit like the dusty old ledgers used in accountancy firms, with one major difference: everyone, from Beijing to New York to Montevideo, has the same ledger. If one accountant adds a line to her ledger, it appears in everyone else’s. In other words, when one line of accounting code, or block, is created in the blockchain, everyone can see and verify it.
This makes double entries impossible, and it creates a decentralized but fail-safe mechanism for keeping track of transactions. The thing that makes Bitcoin so much more trustworthy than traditional money is the ledger. It only records legitimate transactions, which is key to the whole system. After all, if the ledger were full of fraudulent transactions – say, people trying to spend the same bitcoins twice – no one would trust it.
How do you ensure the blockchain only contains legitimate transactions? In a word, mining – a reward system that compensates users for helping keep the ledger trustworthy.
“Proof of work” is what keeps Bitcoin users honest.
Remember the double-spending problem? If you want to make sure someone doesn’t spend a legit 20-dollar bill in one store and a counterfeit bill next door, you can check the serial numbers on the banknotes.
Bitcoin miners do exactly that – they’re checking transactions to make sure users aren’t spending bitcoins twice. Or rather, their computers run software that does this for them.
Verifying transactions is like comparing thousands and thousands of individual serial numbers every second, and it requires lots of computational work. Basically, thousands of computers in the Bitcoin network have to run software that either affirms or rejects transactions.
As part of this process, these computers “mine” by solving very complex math problems – digging and blasting their way through digital mud and rock until they strike gold in the form of solutions to the problems.
The purpose of all this effort is called proof of work. Once a problem has been solved, thus creating a new block in the chain, every user knows that a certain amount of computational work has been devoted to ensuring that the transactions it contains are legitimate.
Why do miners spend their money on electricity to run this software? Well, it’s a bit like entering a lottery. Creating a new block unlocks new bitcoins. The odds of winning this lottery are around 1 in 21 trillion, but the rewards are high. In the spring of 2021, for example, solving one of these problems netted one miner 6.5 bitcoins – around $215,000. As of 2022, data from Coinbase shows there is currently 18.9 million Bitcoin (BTC) in circulation.
Miners can’t create endless new bitcoins, that would devalue the currency, after all. So Bitcoin’s protocol only allows for the creation of 21 million bitcoins. Once these have been mined, that’s it. After that point, miners will receive fees rather than new bitcoins as a reward for their work.
Connection between Gold & Bitcoin
There are some striking parallels between gold and Bitcoin mining. In both cases, for example, most of the work in the early days was done by individuals. Like the prospectors who flocked to places like California and Australia during nineteenth-century gold rushes, the first Bitcoin miners relied on their own – limited – resources.
Rather than panning for gold in creeks, they improvised “mining rigs” – computers set up to solve algorithms, create new blocks in the chain, and earn bitcoins. That’s changed, though. Like gold, which is mined by huge companies using industrial equipment, Bitcoin mining is now largely carried out by global groups with more computing firepower than most individuals can muster.
Solo Bitcoin miners can’t keep up with their industrial competitors. Mining was a solution to a puzzle earlier digital currencies had failed to crack. Though many of these Bitcoin forerunners had been well designed, they couldn’t motivate enough people to adopt the currency. Nakamoto’s innovation was the mining reward system.
At a stroke, it created both a community of enthusiastic pioneers and a refereeing system that was fairer and more transparent than the traditional payment systems provided by banks. That’s because mining is permissionless – anyone can participate. And because no single person or institution can control global mining, no single entity can control transactions in the Bitcoin system.
It might be permissionless, but mining isn’t easy. In fact, the Bitcoin protocol makes verifying payments increasingly difficult. Each new transaction yields a more complex mathematical problem than the previous transaction. The upshot is that you need more and more computing power to verify payments and generate new bitcoins. Slowly but surely, the early pioneers – individuals running improvised mining rigs in their bedrooms and basements – have been displaced by mining pools. These well-financed, highly organized groups can deploy more computing power than most individuals can afford.
Take computers tailored to Bitcoin problem-solving. These use application-specific integrated circuits, or ASICs. A single ASIC-based mining computer typically costs north of $10,000. Then there’s the cost of the electricity needed to run it over long periods of time. Add in the extraordinarily low odds of solving the algorithm for a new block, and it’s easy to see why mining is now an activity beyond the reach of solo hobbyists.
But mining isn’t the only way to get hold of Bitcoin.
A bitcoin is essentially a unique series of digital numbers. They’re stored in an account, which in turn is made up of a unique sequence containing a private key and a corresponding Bitcoin address. Before you can start using bitcoins, you’ll need one of these accounts, which are called wallets. There are a couple of options here, and each has its own advantages and disadvantages.
Before choosing your Bitcoin wallet consider security and accessibility.
In the same way that you keep bills in a leather wallet, you’ll be keeping number sequences in your Bitcoin wallet. Unlike a regular wallet, however, you’ll need a key to access its contents. This is the private master key – a randomly generated 64-digit number that only you can locate.
Broadly speaking, wallets come in two forms: hot and cold. The former are always connected to the internet, meaning they’re always active – hence “hot.” The latter are “cold,” by contrast, because they’re always offline. Two factors determine the pros and cons of each kind of wallet: security and accessibility.
Let’s start with hot wallets. One option is a desktop wallet, which is downloaded onto your computer. Here, you’ll be storing addresses for acquiring and sending bitcoins on your laptop or PC. The advantage of this setup is that you’re not storing anything on third-party servers, which reduces your risk of being hacked. The downside? If you want to access your crypto-assets, you’ll always have to have your computer handy.
That brings us to mobile wallets – apps downloaded to your phone. These give you a lot of flexibility; you can receive and spend bitcoins wherever you are, not just when you have access to your computer. But they also expose you to the risk of losing access to your cryptocurrency if your phone is lost, stolen, or badly damaged.
What about cold wallets? Hardware wallets store cryptocurrency on hardware devices that look like traditional USB thumb drives. These are very secure, but setting them up requires a fair amount of technical know-how. A simpler option is the paper wallet. As the name suggests, this involves storing private keys on a piece of paper. Paper wallets provide the highest level of security of any wallet. Provided you’ve generated your master key securely and have a safe place to store it, they simply can’t be hacked. There’s one significant drawback, however: the fragility of paper and ink, which can tear, fade, run, be mislaid, or get destroyed by water or fire.
We’ve already looked at one way of acquiring bitcoins – mining. Let’s assume, though, that you’re not one of the few investors with the time, money, and inclination to mine Bitcoin. What’s the alternative?
Exchanges.
The easiest way to join the Bitcoin revolution is to use exchanges, which are cryptocurrency bazaars or marketplaces that connect buyers and sellers
They’re like local movie theaters. No two countries are alike and national tastes vary, but the latest blockbusters tend to be screened everywhere. Similarly, every country and region has its own cryptocurrency exchanges. The “blockbusters” here are the basic services they offer – which are ways of buying and selling bitcoins. The reason these exchanges aren’t identical is that they have to interface with local banking systems and currencies.
Once you’ve bought your ticket, you can choose how to use it. You can buy a few bitcoins, a lot, or none at all – just as you can decide to sit with your back to the movie screen. The key here is research. Look into local exchanges, and choose one that fits your needs. A good place to start is the website coinmarketcap.com, which lists more than 300 exchanges around the world.
What happens once you’ve found the right exchange? Well, it’s a bit like opening a bank account. You’ll be asked to provide proof of identity and submit copies of your ID or passport along with a photo of yourself. Some exchanges run test deposits on your bank account to confirm the details you’ve submitted.
Once you’ve gone through these bureaucratic steps, you’re ready to buy bitcoins. You can use a debit or credit card, or transfer fiat currency directly from your bank account. The latter option costs less – credit cards in particular come with higher transaction fees – but you’ll usually have to wait a couple of days before you can access your bitcoins. After that, it’s entirely up to you.
There you have it! The basic building blocks that will allow you to invest in Bitcoin and invert Charlie Munger’s thoughts on Bitcoin! Remember, though, that there’s one golden rule to investing, whatever the asset: take your time, and make decisions based on research and your own common sense.
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