This article was originally written and released in 2021 but was updated and revised in 2023
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Of all the cryptocurrencies in the world, there’s one that stands out from the crowd as the most well known and perhaps most trusted name of all. That is of course, the original cryptocurrency: Bitcoin.
Settle in because this one is gonna cover a lot of ground
Oh and by the way: This content is for educational and entertainment purposes only. Nothing that follows is financial advice.
What’s the deal with Bitcoin?
Bitcoin was invented in 2008 by an unknown person or group of people pseudonymously known as Satoshi Nakamoto. Through an innovative combination of mathematical and computer science concepts such as cryptographic hashing and Merkle trees, Nakamoto effectively invented the technology of blockchain, which underlies almost all modern cryptocurrencies.
In a 2008 whitepaper, Satoshi Nakamoto presented the idea of what they described as "a peer-to-peer electronic cash system"
The idea was, and still is, groundbreaking. However, over the years, some of Bitcoin's biggest advocates have become vocal critics of its ability to meet this description, arguing that due to its small block size and rate at which blocks are produced, it does not allow for adequate scaling. They argue that it has diverged from that original goal towards an alternative use case: that of a store of value (SoV), not unlike gold
This led to several forks of Bitcoin like Litecoin, which bills itself as "the silver to Bitcoin's gold," Bitcoin Cash which claims to align with Satoshi’s original vision as a P2P digital cash, and Zcash which draws heavily from the cypherpunk roots and adds additional privacy features (more on that later). It also led to the creation of the Lightning Network, a scaling solution aiming to increase transaction throughput and improve the UX for everyday users.
This article will focus on the idea of Bitcoin as money. If you’d like to learn more about how the network functions and see the arguments for and against it’s Proof-of-Work consensus system, check out this article.
What is Money?
The history of money's use in commerce is fascinating. For most of history, all commerce took place on a barter system: "I have this thing, you have that thing, let's trade!" Unfortunately, there were some rather glaring imperfections to this system. What if you don't want what I have, but I want what you have? As you can imagine, that could lead to disputes, theft, and even wars.
Alternatively, let me explain with an example: imagine I have three goats to trade, and I want rice. How much rice is a goat worth? How much rice is three goats worth? If, for example, one bag of rice is only worth half a goat, how do we reconcile the difference? In modern days with refrigeration, you might just suggest weighing a certain amount of goat meat to make the trade, but even then, how many kilos of rice for how many kilos of meat?
This is the reason money was invented, to fulfill three core functions:
1️⃣ A medium of exchange: it must be something that can easily change hands. Goats then, are not a great medium of exchange as bringing more or fewer goats to trade for a specific item or service poses numerous problems.
2️⃣ A store of value: it must hold its value over time. Once again, goats or any living animal is less than ideal as they age and eventually die.
3️⃣ A unit of account: by providing a relatively stable value over time, one only needs to know the current value of what they're buying or selling in relation to a given currency, such as the US dollar, rather than having to maintain somewhat arbitrary value relationships between many goods.
The Origin of Money
Like so many things, money was effectively created in ancient China. First, shells were used, and later base metal coins were created. Metal currencies played major roles in the development and growth of the empires of China, Lydia (Turkey), Greece, and Rome. In fact, King Croesus of Lydia is credited with minting the first pure gold coins in the 6th century BCE.
I'm not sure whether he knew it at the time, but he was effectively setting off thousands of years of dominance of gold as the preeminent store of value. The function of gold as a store of value outlasted the Republic of Rome as well as the Empire, spread across the globe, and persists until this day, where gold can be found in nearly every investor's portfolio.
But while gold certainly fulfills its duty as a (long-term) store of value, since it is an untarnishable metal of great beauty and relative usefulness, it comes with many downsides. Let's talk about those.
The Gold Standard
While gold has traditionally been used as a currency, it has an obvious issue - it's heavy and impractical to carry around. As a medium of exchange, it can only be used directly and locally. Consider the example of buying a Lamborghini Huracán, a car that's highly prized amongst the crypto rich. With a starting price of $248,295 USD, it would take over 3 kilograms of gold at current prices to make that purchase. Clearly, carrying such a large amount of gold is not feasible. To address this problem, paper money was invented, which allows for transactions with something that's agreed to have value.
The idea that bank notes represent a stake of precious metals has often given paper money its value. The United States initially used a bimetallic system of metal coins, where silver and gold were valued in a ratio relative to each other, and the coins were weighted proportionately to their face value. However, the bimetallic system was abandoned in favour of paper money (which was not backed by anything) when the Legal Tender Act was passed in 1862, to finance the Civil War.
The gold standard, where bank notes are redeemable for gold, was officially adopted by England in 1821 and subsequently by many other countries. The United States joined the international standard in 1879. However, in 1933, the gold standard was gutted and replaced with the Bretton Woods system. Under this system, private citizens could no longer redeem their dollars for gold, and the standard of redemption was offered only to foreign governments. In 1971, Richard Nixon announced the transition away from the gold standard to a fiat monetary system.
Fi-what?
Money that is backed by the gold standard is known as hard money. Hard, as you can imagine, like metal. Money that is not backed by anything (besides faith) is known as fiat money. Fiat comes from the Latin "let it be done" and in this context means, “money has value because we say it has value.” It is so decreed.
The adoption of fiat money was logistically beneficial for the United States and other countries that would come to adopt it. After the stock market crash of 1929, the Great Depression began, and thousands of bank failures occurred. This led citizens to begin hoarding gold to protect their wealth. Of course, only a limited few had the luxury to do this, and with a monetary system reliant on the gold standard, the government had no way to provide for its citizens. So, like almost all other countries that had already done before them, they abandoned the gold standard.
This proved especially beneficial for kickstarting the US economy, especially during World War II when the government printed enough money to manufacture both an economic recovery and an end to the war. But many wondered if there would ever be a return to the gold standard, or perhaps some other form of hard money.
Enter Bitcoin
As I mentioned, Bitcoin was designed to be a peer-to-peer electronic cash. But that’s not all. Built into the design of the currency are some rather big ideas about monetary theory. Bitcoin has a hard cap. Therefore, once the final bitcoin is mined, there will be no more ever created. This means that while Bitcoin is technically operating on a set inflation schedule (for about another hundred years), it will eventually become disinflationary — not deflationary as many often claim.
The hard cap, combined with Bitcoin’s programmatic inflation schedule, provides a kind of predictability to its long-term role as a store of value which even gold can’t offer. The assumption for a long time was that gold was scarce, but as technology for discovering and extracting gold has improved, the stock of gold entering the market has far outpaced expectations, and mining production has been able to remain consistent for years, meeting nearly 75% of all demand with gold recycling making up the remainder.
Interestingly though, the vast majority of demand for gold comes not from utility but from investment. Effectively, this means that gold’s demand comes mostly from people hoarding it, which implies that much of gold’s natural “scarcity” is relevant only because it is enforced by an artificial scarcity produced by locking it away.
Now, a case could be made that this is how all supply and demand economics work. In fact, artificial scarcity is what drives the valuations on diamonds, oil, and even Disney movies! I might argue, though, that the need to inflate value through hoarding and production limits shows just how worthless (or at least overvalued) something is.
This is not true of a hard cap. For example, the Earth itself is extremely valuable because, at present, there are no alternatives. Creating an alternative gold-like store of value is simple. In fact, as I’ve pointed out, many have already come to prefer Bitcoin to gold as a store of value due to its true hard cap.
Hoarding gold also has a number of downsides, both economic and ethical. Economically, the transport and storage of gold is expensive. During periods of falling gold prices like we saw for nearly 20 years from the 1980s to the early 2000s, those who bought gold at the top were frankly hemorrhaging money, both in unrealized losses and in storage costs (or asset management fees).
In fact, many argue that gold is not an adequate store of value, and it’s easy to agree when you view its performance over investing periods like 1934–1970 and 1980–2000. For this reason, whenever you encounter a gold bug, you can probably guess when they began investing.
I hold gold in my portfolio through my robo-advisor account, but I’ve said on multiple occasions that I’d like to see Bitcoin (or something else) replace gold as the international store of value. And that’s because of another issue I want to discuss: the ethics of gold.
The Ethical Case for Bitcoin as a Store of Value
You see, for all the fuss people make about Bitcoin’s environmental impact, what they often neglect to include in any comparison is the environmental impact of the gold industry, which Smithsonian Magazine called an “environmental disaster” and which some have even claimed has an environmental impact far worse than Bitcoin.
Beyond environmental concerns, the artificial scarcity of valuable resources like gold, oil, and commodity food products or water is unethical. Gold, in particular, has important uses in modern medical applications, such as the diagnosis of diseases like HIV and malaria. It's also a key component in various technologies, including solar panels, cell phones, and even space telescopes. Lowering the cost of gold could have significant implications for improving technology and medicine leading to positive externalities in across industries, borders, and classes.
Hoarding Bitcoin, however, should have no negative consequences. While disproportionate allocation could create a wealth gap and power imbalance in a global currency, all money (including Bitcoin) is just a social construct, as historian Yuval Noah Harari argues in his book Sapiens. Therefore, new forms of currency will always be created as needed. If a select few hoard Bitcoin, people will simply stop using it as a currency and develop a new one to replace it.
There’s another major issue with gold and its one that even Bitcoin is not immune to.
Custodial Risk
As previously mentioned, carrying gold is impractical and transporting it is very expensive. For this reason, much of the world's gold is kept in custody. The Federal Reserve Bank of New York, located beneath New York City, holds the majority of the world's gold. The second largest store is in Berlin, in the vaults of the Bundesbank. From there, gold can be found in various central banks around the world and in the custody of some of the world's largest private banks, such as Barclays.
This means that the vast majority of gold "owned" by investors will never be accessible to them. They can buy and sell shares of gold, but little else. While this is ideal for most people, it does leave the door open to a number of risks around centralization. I've talked about the dangers of centralization before, including in my article about stablecoins. In many ways, these flaws are what peer-to-peer interactions aim to solve.
This type of custody increases the risk of theft and censorship. While large-scale gold heists like the one portrayed in Die Hard with a Vengeance may not be possible, other forms of theft are. For example, consider the country of Venezuela, which was once seen as the envy of the world for using its oil wealth to provide a higher standard of living than most other countries. Since the 1960s, the CIA has aimed to destabilize left-wing political movements in Latin America, supporting several military coups and right-wing dictatorships, including a coup in 2002 against the former leader of Venezuela, Hugo Chavez.
However, in the end, it was their dependence on oil that contributed the most to their economic downfall. When oil prices began to fall, there was a steady decline in economic output as their main export became less valuable. Seeing an opportunity to show strength, the US, under the leadership of former president Trump, instituted aggressive sanctions which blocked Venezuela from refinancing its debt and cut off all major sources of income to the country.
Even as hundreds of thousands of people died, Trump continued to mock the situation, claiming that the US would win this particular dispute, and that “to the winner go the spoils” (referring to the country’s rich oil reserves).
The situation in Venezuela is undoubtedly complex, and it is important to acknowledge the human rights violations committed by the country's leader. However, it is also worth examining the issue of gold ownership in this context. When the Bank of England refused to release Venezuela’s gold to them even as the pandemic ravaged the country, it underscored a crucial point: gold, like cryptocurrency, is only truly secure when it is under one's own control.
Decentralization & Self Custody
Custodians play a significant role in introducing centralization risk into the financial system. This risk can be mitigated through one of the core principles of blockchain, which is decentralization.
To achieve this, all transactions are recorded in a publicly available ledger, which is duplicated and stored across a vast network of geographically distributed nodes. Users can self custody their funds with a Bitcoin wallet.
The word wallet is a bit misleading though as despite being an easy way to check balances and even transact with the cryptocurrency, wallets do not store any Bitcoin. Bitcoin lives on the blockchain, no one ever truly possesses it.
A wallet is like a keychain. It holds a set of cryptographic keys that unlocks only one door: the door to the outputs of all transactions that lead to, originate from a given a address. Think of it like an impenetrable glass ballot box in the middle of a public square. Anyone can put something in, and any one can see what’s inside, but only one person can open it and thus transfer the contents out.
The only person who can access these funds is the person with the keys, but these keys are just a very complicated and random string of text, and while it would be nearly impossible to guess them, if someone gets a hold them by another means they would be able to do whatever they want with your Bitcoin, no matter where they are in the world.
So guard them well. Never store them online. Never share them with anyone else. And don’t carry them around with you or leave them in easily accessible places. The best option is usually a fireproof safe, though those with eidetic memory may prefer to keep no physical copy.
You may have heard of a hardware wallet. This is once again a confusing term, as a hardware wallet simply generates keys offline and adds an additional layer of friction to the process of transacting. It does not allow you to store coins off the blockchain, nor does it stop others from being able to access your Bitcoin should they get a hold of your keys.
It is still a very good idea to use one. Think of it like a Two Factor Authentication (2FA) key that you can use to add another layer of security when logging in to important websites. It doesn’t remove all risk, but it does reduce it.
While careful self custody of a cryptocurrency like Bitcoin removes a lot of the centralization risks from finance there are a number of reasons that people choose to custody their assets. One is that they don’t necessarily trust themselves to keep their assets safe. This is an understandable fear but custody for this reason is contrary to the core principles of decentralization.
A much more common reason why people choose to custody Bitcoin is to earn a yield from lending, to borrow other assets against their Bitcoin, and to engage in other kinds of financial activity.
Because Bitcoin is not a smart contract blockchain, there is no real way to do these activities in a trustless way. There is somewhat of a workaround though…
Wrapped Bitcoin
Turing complete blockchains like Ethereum allow for smart contracts where the code sets terms which neither party can break. Let’s look at the example lending and borrowing. To do this with only the Bitcoin blockchain you would need a lot of trust, either in the other party’s word, a formal contract enforced by a country’s legal system, or a regulatory framework that guides third-party custodians.
These layers of trust would have disgusted Satoshi. They are too frail, too corruptible.
Now let’s look at a decentralized lending protocol like Aave. Aave uses open source, publicly auditable smart contracts. Users can confirm for themselves what the smart contract is enforcing. If it says they can lend one asset and borrow another against it, that no one else will come between them doing so. They can pay back their debt and withdraw their original asset, they can even sell or trade their debt to others or use it in other ways thanks to the composability of decentralized finance.
In order to do this with Bitcoin one first needs to get their Bitcoin onto a smart contract blockchain like Ethereum. Because Bitcoin itself doesn’t allow for smart contracts, doing so once again requires the help of a custodian. The preferred way to handle this interaction is through Bitcoin multisignature wallets controlled by decentralized autonomous organizations. This could then allow for automated code-based execution, eliminating the need for trust in individuals.
Currently, Wrapped Bitcoin, one of the most popular assets in decentralized finance, is handled by the Wrapped Tokens DAO, jointly initiated by Kyber, Ren, and BitGo.
Wrapping ≈ Bridging
Wrapping (in the context of cross-chain transfers) is basically the same thing as bridging. The latter is usually defined as assets going from one turing-complete blockchain (capable of runing smart contracts) to another turing-complete blockchain; the former can mean assets going from a turing-incomplete blockchain (like Bitcoin or Litecoin) to a turing-complete blockchain like Ethereum. They are both otherwise the same thing.
Ethereum.org has a fantastic explainer on how bridges work, the various types, and their tradeoffs, but what’s important to understand with respect to WBTC is that it employs a lock and mint approach.
Bitcoin is locked into a multisig wallet on the Bitcoin network and an equivalent amount of WBTC is minted on the Ethereum network. When the WBTC is to be unwrapped, it is burned on the Ethereum network and the corresponding BTC is unlocked and released from the multisig wallet. Given that it takes place on the blockchain, the entire process is auditable and can be easily viewed via the the WBTC Dashboard.
Scaling Bitcoin
Another key benefit of Wrapped Bitcoin is that it allows for scaling of Bitcoin transactions. This allows users who believe in the value of Bitcoin but who are not able to afford the time or expense of using the Bitcoin network to transfer their tokens. After all transactions on the bitcoin network take upwards of ten minutes to confirm, making it less than ideal for daily use. These transactions can also cost several dollars.
WBTC which has the same value as BTC, can be transacted on an Ethereum layer 2 like Optimism in seconds for under 25 cents. But, while this is a very popular way to transact, many feel that it is too far of an abstraction and introduces undue risk.
This has led many to work on scaling solutions that interact natively with Bitcoin. There are several new and projects launched by the Bitcoin community to address scaling, including rollups and sidechains. However, most widely recognized protocol is the Lightning Network.
The lightning network is a state channel that allows users to pay a transaction fee to move funds off chain into a lightning node. There they can transact at very low cost for as long as they wish, but none of their transactions are written to the Bitcoin blockchain. Only when they choose to settle is the output of all of those transactions finally written to the mainnet.
For more information about how exactly this works, I recommend watching this video from Finematics or the more technical, you can check out the whitepaper.
Proponents of the Lightning Network claim that it solves the Bitcoin scaling solution, and introduces a multitude of new options for payments and even potentially native (well, layer 2) DeFi on Bitcoin. This is not just an exciting idea, it is absolutely necessary for Bitcoin’s potential to scale as a currency.
Critics argue that state channels are relatively inelegant and that Lightning requires all participants to essentially stake some Bitcoin by prefunding their wallets and only works if everyone with whom you want to transact has already opened a channel at the time you want to send them money.
Worse still, many of the most popular lightning wallets like Bluewallet, Wallet of Satoshi, and El Salvador’s Chivo are custodial implementations. It is also worth noting that while claims have been made that Lightning offers privacy, researchers working on the NYM project have concluded it’s quite easy to deanonymize Lightning transactions.
This brings me to an important point.
Privacy is Fundamental
Bitcoin is not a private cryptocurrency, as anyone with internet access can view transaction details, including the transaction amount and the wallet addresses involved. While the sender and receiver's identities are not revealed, transaction details themselves can provide significant information to anyone with the technical know-how to analyze them. This poses serious risks to the usability of Bitcoin and similar cryptocurrencies, which Satoshi was aware of if you read their old Bitcointalk Forum posts.
This lack of privacy has prompted the creation of privacy-focused cryptocurrencies, like Zcash. Zcash is a fork of Bitcoin that adds increased privacy features to the original protocol, such as shielded transactions. A shielded transaction shows neither the sender nor receiver's address, nor the transaction's value.
Zcash uses zk-SNARKs (Zero-Knowledge Succinct Non-Interactive Argument of Knowledge) technology to enable private transactions. This technology allows verification of a transaction without revealing any details of the transaction itself. Zk-SNARKs generate a proof that the transaction is valid, without revealing any information about the inputs, outputs, or amounts involved. This proof can be verified by anyone on the network, ensuring that the transaction is legitimate.
While Bitcoin and other cryptocurrencies have made significant strides in decentralization and security, the lack of privacy remains a significant concern for many users. Implementing a similar approach to what Zcash offers is theoretically possible but would likely require a hard fork, which could lead to most users treating the pre-fork Bitcoin (without protocol-level privacy features) as the officially recognized version. This is effectively what happened when Zcash forked from Bitcoin.
If that happens, we will still be having this conversation years from now, assuming anyone still uses Bitcoin at that point. Given how crucial privacy is to the fungibility of a currency, and thus necessary to fulfill the core functions of money, Bitcoin without privacy will forever be relegated to the role of digital gold.
And that's probably not what Satoshi would have wanted.
Until next time,
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