What is Backing Bitcoin?
What is Backing Bitcoin?
Base-layer monies are not backed by assets, they are backed by ideas.
A common criticism of Bitcoin is that it is not backed by anything.
Similar to gold coins and dollar bills, Bitcoin’s value is not backed by any claim on other assets, rather its value is supported by its own inherent properties.
To understand what is ensuring Bitcoin’s continued value, let’s examine how it compares to other monetary assets.
WHAT IS BACKING GOLD?
The owner of a gold coin has no rights or claims on other commodities. In that sense, gold is backed by nothing other than itself. Gold is a base-layer monetary asset.
That is not to say that gold cannot have value. Gold’s value exists in proportion to its usefulness. Its physical properties, such as its malleability and resistance to corrosion, make it useful in industries ranging from dentistry to electronics. However, those uses pale in comparison to gold’s primary use as a store of value.
Gold is relatively robust across the criteria for money, namely durability, portability, verifiability, divisibility, fungibility, and scarcity. When compared to other commodities, gold was more useful throughout history as a monetary asset because it exhibited such robust characteristics. Workers needing to store and exchange the value of their labour could do so more effectively using gold than they otherwise could using other commodities.
Gold’s scarcity is what makes it particularly good at storing value. There is no way for gold to be acquired except through resource-intensive means. Finding, mining, extracting, refining, transporting, and securing gold all consume time and energy. If these processes required fewer resources, then more gold could be brought to market annually at a cheaper cost, thereby inflating the supply and depressing the price.
Gold is hard to come by, therefore gold coins can be viewed as evidence of expended valuable resources.
The degree to which gold can be relied upon to have value in the future, either for industrial or store-of-value purposes, is due to the immutability of its physical properties. All of gold’s properties, from its resistance to corrosion to its scarcity, are established through the laws of physics. Gold can only be created inside stars, and no alchemist can change that fact. One can reasonably expect that gold’s properties will be stable over time, and by extension be stable in its usefulness to satisfy needs, namely storing value.
Although owning a gold coin does not guarantee any claim on other assets, there is assurance in the immutability of its physical properties based on physics.
Gold is “backed” by physics.
WHAT IS BACKING THE DOLLAR?
Prior to 1971, US dollars were redeemable for gold, however, after the Nixon Shock of 1971 the redeemability of dollars for gold was ended, thereby making the dollar fiat money. The dollar’s value no longer relies on its ability to be redeemed for a physical asset, but on the government’s guarantee that it will have value in the future.
Just as gold’s value can be described in proportion to its usefulness, so too can a dollar’s value. Laws put in place by the government denominate taxes in dollars. A dollar’s usefulness is therefore established in its ability to settle debts within the jurisdiction of the government. Refusal to pay taxes with dollars may result in legal consequences, such as fines and penalties, which themselves must be paid in dollars. The inevitable result of refusing to use dollars is imprisonment as a form of physical punishment.
The denomination of taxes, fines, and penalties in dollars, as well as legal tender laws that enshrine dollars as an acceptable form of payment, ensures a baseline usefulness for dollars. Individuals and businesses alike will continue to demand dollars so long as the government assures this usefulness in the future.
In countries where such assurances have been rescinded, such as India’s demonetization of the 500 and 1000 Rupee banknotes in 2016, fiat money’s value can cease to exist. A now-defunct 500 Rupee banknote is no longer useful for buying goods, paying taxes, or even exchanging for the new 500 Rupee banknote. It is only useful as paper.
The lack of inherent usefulness of fiat money, whether in the form of paper notes, metal coins, or digits on a bank statement, demonstrates that its value rests upon popular consensus, which itself relies on government assurances. A dollar is only useful in paying debts so long as the government maintains that usefulness under the threat of physical punishment.
Dollars are “backed” by government authority and the threat of physical punishment.
WHAT IS BACKING BITCOIN?
Similar to gold, Bitcoin has properties that make it useful. Whereas gold’s properties are exhibited in physical space, facilitating uses in dentistry and electronics, Bitcoin’s properties are exhibited in digital space.
To illustrate this difference, consider how a paper letter is comparable to an email in its ability to convey messages. The fact that an email exists in digital space does not diminish its usefulness, rather it should be seen as an enhancement as it can be delivered faster than physical letters. In the same way, Bitcoin’s digital nature allows it to fulfill purposes that would otherwise be impossible if it existed physically.
Like gold, Bitcoin’s properties make it particularly useful in storing and exchanging value:
A supply cap of 21 million bitcoins, each divisible into 100 million satoshis
An immutable inflation schedule that diminishes by half every four years
An issuance system that uses a resource-intensive and automatic difficulty-adjusting process called mining
A globally decentralized network that provides final settlement of transactions in minutes
A lack of central authority to restrict, prevent or otherwise encumber transactions
A zero marginal carrying cost
An ownership structure that relies on private keys
A publicly transparent record of all transactions and address balances
These properties enable Bitcoin to match or surpass gold as a monetary asset in terms of divisibility, portability, verifiability, durability, fungibility, and scarcity. Just as gold’s scarcity made it a useful store of value for millennia, so does Bitcoin’s absolute scarcity make it a superior store of value. Unlike fiat money’s reliance on government authority to have value, Bitcoin’s value is inherent in its properties and people can voluntarily choose to adopt or reject it as they please.
Ultimately, the immutability of Bitcoin’s properties is what ensures that can hold value over time. Whereas gold’s properties are assured through the laws of physics, Bitcoin’s properties are assured through the mathematical infeasibility of changing them to the detriment of its users.
Bitcoin has been repeatedly updated through a lengthy, rigorous, and public process by which new features are vetted prior to release. Even after release, the decision to accept and download the software update ultimately rests with the decentralized and self-interested network of nodes, miners, and exchanges. Bitcoin has no board of governors, no CEO, no head office, no cabal of leaders who hold privileged rights, only a decentralized network of peers. The proposition that such a decentralized network would voluntarily diminish Bitcoin’s ability to store or exchange value is untenable.
The only real possibility of Bitcoin changing its properties for the worse comes from the threat of malicious actors. Issuing new coins without mining, accessing other peoples’ bitcoins without their keys, or crashing the Bitcoin network through the prevention, restriction, or reversal of new blocks are all real threats, but are so economically infeasible that they border on impossible.
The SHA-256 hash function, which provides security for many of the most popular Internet protocols, is what underpins Bitcoin’s security and ensures that no new bitcoins can be mined save through resource-intensive mining. The possibility of a 51% attack, whereby more than half of mining hash power is acquired or coordinated to act maliciously is also economically infeasible, as the potential reward is significantly outweighed by the risks and resources required to execute such an attack.
Government or corporate actions against Bitcoin have also proven to be impotent. As evidenced by the China Bitcoin crackdown and the 2017 block size war, even influential corporate or government entities that control the majority of mining power cannot alter Bitcoin. The game theory dynamics of Bitcoin’s globally decentralized network means that any jurisdiction that opposes Bitcoin will simply cause a capital flight towards more friendly locations, taking with it mining hardware, jobs, talent, and tax revenues. There are few economic incentives to banning Bitcoin, while there are substantial economic incentives to welcoming Bitcoin.
Government crackdowns can suppress Bitcoin’s price in the short term, but unless the popular demand for store-of-value assets is diminished, or Bitcoin’s ability to meet that demand is compromised, Bitcoin will continue to grow.
The proliferation and geographical distribution of Bitcoin nodes, miners, developers, and holders exert a network effect on Bitcoin’s security. As the network grows and is distributed, the more difficult it becomes to attack it, thereby incentivizing more people to join due to its enhanced security. There is simply no economic or technological way to change Bitcoin’s properties that would compromise its usefulness in storing and exchanging value.
Bitcoin is valuable to the degree that its properties are useful in storing and exchanging value.
It is not “backed” by any assets in the traditional sense, only by the assurance that its properties are immutable. The mathematical infeasibility of detrimental changes to Bitcoin is based on cryptography, game theory, network effects, and economics.
Bitcoin is “backed” by ideas.