I’ve spent a lot of my Bitcoin hater energy taking on explanations of how bitcoin is supposed to sustain its value despite having no use other than as a monetary instrument. But others will point out that one can, in fact, do other things with the Bitcoin system other than trade. This is good; I think Bitcoin, or cryptocurrencies in general, can potentially be saved by thinking in this sort of direction. Unfortunately, while some of these features of Bitcoin and other cryptocurrencies come close, as far as I’ve seen they aren’t orchestrated in a way to maintain a value, nor are they really designed to do so.
Smart property is an idea proposed to use token amounts of bitcoin to represent titles on certain kinds of devices. In the rest of this article, I will consider the minimum amount of technical detail necessary to make my points, however, you can read more about it here. Suffice to say, this hypothetical system would configure the device to be disabled unless the owner of the bitcoin token is operating it.
While this is certainly useful, and as such should give it value, the value is inherent in the tiny amount of bitcoin currency that is required. While on the one hand, being able to do so much with such a small amount of bitcoin may make it seem all the more valuable, it requires so little as to basically no longer be scarce, precluding it from having a high price. As far as I can tell, it only takes one Satoshi, of which there will be quadrillions over time. Recall that air is extremely valuable, but so far it’s free.
So, what if there were a feature that required more bitcoin to use? Smart property is just one kind of contract you could enforce with the Bitcoin system. There are other sorts of contracts, such as escrow, which involve larger amounts of bitcoin, because you have to actually buy goods or services for it to be of use. With an escrow contract, a buyer and seller could deal with a trusted third party who will lock the bitcoin used in the transaction until the product or service has been delivered.
Consider an example. I’m holding 1000 Federal Reserve Notes (FRN) that I use to buy 1 BTC in order to buy a television, along with an escrow service, using a Bitcoin escrow contract. The escrow service is a markup on top of the price of the television. The Bitcoin contract feature itself is, as far as I understand, free to use.
Compare, as I like to do in these articles, with a hypothetical consumer market for gold. Supposing I’m willing to pay as much as 1000 FRN for 1 oz of gold. If, in an information lapse, the price of gold drops to 800 FRN/oz, I will jump on the opportunity and buy. Enough people acting like me would cause the price to approach 1000 FRN.
So let’s similarly assume the price of 1 BTC drops to 800 FRN. Am I going to jump on the opportunity to buy 1 BTC, since I was originally willing to spend 1000 FRN? Well I certainly can’t buy the television and escrow service with that 1 BTC anymore, I’d need 1.25 BTC in the current market. So I could spend the same 1000 FRN on 1.25 BTC and get the same television with the same escrow service. It doesn’t have the same feedback loop effect as with gold, at least not immediately.
I spoke earlier of scarcity. What if there were a whole market of people like me? Since we’re now demanding 1.25 BTC instead of 1 BTC to get a television with escrow, the supply of bitcoin will decrease. Perhaps it will run out, and this scarcity will rebound bitcoin back to 1000 FRN per 1 BTC or maybe higher. What this seems to imply, thinking about this phenomenon on a macro scale, is that if you remove speculation, the “market cap” of bitcoin is the sum total of the price of all goods that consumers try to cram through it (specifically, consumers that want something out of the network that they couldn’t get without it, such as escrow contract capabilities). For instance, if there were perfect information, and the entire bitcoin market consisted of 1000 people buying televisions with escrow at the same time, 20 million BTC would be priced at roughly 1000 televisions with accompanying escrow services.
I’ll admit, pondering this consideration as I was writing, almost caused me to retire my hater status. However, what this fails to consider is what happens next. What do the television sellers do with it? Are they then going to make another purchase of the same price? Is there going to be a steady stream of such purchases? It seems to me that there is, in fact, a limit to how many goods can be crammed through the bitcoin window, and that limit is based on the expectations of the sellers of the products, that there will continue to be such a steady stream. If it ever slows down, confidence can collapse, eventually bringing the price down to zero, as us haters have described so many times before in comparisons with gold. But perhaps this sort of thing has already been solved in the realm of macroeconomics; it’s certainly outside the scope of my ability to make layman arguments. I’m open to anybody calling me out on it.
Proof of Work
Okay, so what if we tied the value of bitcoin to something in the outside world? One argument is that an amount of bitcoin derives value from being proof of a corresponding amount of work done to produce them. A good summary of the argument is here.
I almost dismissed it as the outdated cost-of-production theory of value, but then I looked more closely. In certain unusual situations, it is actually advantageous to expend a certain amount of resources just to prove that you did so. The classic example is getting past a spam filter. The spam filter wants to allow a reasonable amount of messages through, but disallow a barrage of them. If each message costs you a small amount of effort, your incentives align with these wishes.
You can also trade around this proof of work. A bitcoin miner may not care about getting through a spam filter, but somebody else might. The market rate for proof of somebody else’s work would have to be above the cost of production, otherwise the miners would stop. What’s more, the amount of work that goes into a certain amount of bitcoin actually goes up over time. Seems like a slam dunk (assuming it gets widely adopted for these sorts of purposes.)
The problem with this is that if the scarce resource to be expended for an email message is energy in the Bitcoin network, a bitcoin is not a good measure. There is nothing stopping the email provider from spending the bitcoin on the market again, leading it through many spam filters over time.
The system could work if the email provider required the sender to burn the amount of bitcoin to take it out of circulation. But what would be the incentive for an individual email provider to do so? It would cost the sender the same amount, and benefit the email provider more, to accept the bitcoin as payment. Without altruism on the part of both parties, or a worldwide coordinated agreement, this would never happen.
Okay, so what if the network somehow forced you to burn an amount of coin in order to get a measured benefit out of it?
Namecoin is a fork of Bitcoin, with one key difference: It is possible to register, using the network, a .bit domain name (and similar things) for a rate that’s built into the system, not determined by the market. Who gets the fee? Nobody gets it, it’s burned.
I came very close to calling this article “Why Namecoin is Different”. But then I read one unfortunate policy: Namecoin actually plans to decrease the price of domain purchase over time, to the point where it is eventually, in their words, “negligible”. This payment and burn for a domain name was not designed to give Namecoin value, rather it was designed with an expectation of a pre-existing value to avoid abuse of the system, particularly by early adopters.
There is also a 0.01 NMC “special coin” which holds the domain info, and it’s not clear to me where it comes from. Perhaps this is the “negligible” minimum value that comes from the fee. But if Namecoin domain registration gets so popular that the market rate of the registration fee is no longer negligible, to follow their design they may just change the algorithm to make it negligible again. If they reversed this policy, however, I think it could be a breakthrough.
When comparing with gold markets, us haters like to point out that if gold prices were to drop, it would recover very quickly because of consumer demand. If Namecoin were to fix the incentive system, it would similarly be protected from a dip in price. However, it’s interesting to note that, unlike gold, Namecoin could still hypothetically be vulnerable to a drop to zero. In such a case, nobody would have any more incentive to continue mining it, thus destroying the network itself. However, this seems extremely unlikely, and would probably recover well before anybody had a chance to go home and turn off their mining rigs.
The question of “value from being able to transfer value” is its own topic which I’ve covered in other places. In short, I consider it circular reasoning to argue that a cryptocurrency gets value from facilitating transfer of itself. However, the facilitation of transferring things of established value, I agree is valuable. And that’s what XRP can do within the ripple network. Ripple, in general, is a network designed to trade in debt of other arbitrary commodities. XRP serves essentially the same purpose as the spam filter described above, except that a certain amount is actually burnt in the transaction.
Again, this could have saved Ripple, but XRP was not designed to derive value from being a spam filter. Like with Namecoin registration, fees in XRP are designed to be negligible, but rely on them having at least some sort of market rate so it’s not trivial to obtain a large amount. It seems to me that the folks over at Ripple are encouraging people to see a value in XRP out of nowhere, to facilitate this spam filtering. “XRP has real-world value. How much? That’s up to you to decide.”
I think the reason for this may be that Ripple decided to not have a mining process, but rather created all of the XRP upfront. If XRP were mined like Bitcoin, and the XRP price of transaction remained constant, again I believe they could have had a stable base price.
This can be fixed
No cryptocurrency I’ve looked at so far seems to have this issue figured out correctly. I think this is because in the end, all of these examples of use value are ultimately based on the same sort of circular reasoning as the arguments that claim it can sustain value purely from monetary use. Perhaps some enterprising developers who think like I do, enthusiastic about the technology of Bitcoin but doubtful about the economics, could come up with an altcoin that has all these pieces fit. Then we could wait it out and see which of them are still alive in 20 years.
Original content by Dan, CC0 (attribution appreciated), tips welcome