Tracing back to the origin: Where does the value of Bitcoin and Ethereum come from?

Whenever people mention cryptocurrencies such as Bitcoin, they are always associated with speculation, investment, hype and even Ponzi schemes, as if cryptocurrencies are just a pile of waste paper.

Author: 0xlilackatana

Original article: "A Study of Bitcoin, Ethereum and Economics"

Whenever people mention cryptocurrencies such as Bitcoin, they are always associated with speculation, investment, hype and even Ponzi schemes, as if cryptocurrencies are just a pile of waste paper.

This statement may not be completely wrong, but in fact, there are tens of thousands of dollars of derivatives traded every second in the world's financial markets, and these include stock market indices, CFDs, and spread betting, which are actually just betting contracts, not real transactions. For example, if you buy the XAUUSD gold trading pair on Vintage, your trading has nothing to do with gold. Your trading may not really affect the supply and demand of gold, and you will not really receive gold. This is not Amazon delivering the gold you bought to you the next day. The gold traded by most people in this world is actually just a bill, and you will not really go to New York to pick up the gold. Even in futures trading such as oil or wheat, I have not heard of many traders who will eventually find a tanker or truck to pick up the physical goods. Everyone is almost just doing these transactions for profit. Except for some people who buy gold as a dowry or jewelry, the gold held by most people is just a bill to exchange for gold and they may not see their gold in their lifetime.

So, why do traders buy gold? There can be thousands of reasons, such as hedging against inflation risks. But in the end, there is only one purpose for investing in gold: "Expecting that the next person will pay a higher price to buy from you."

In fact, the characteristics of Bitcoin and gold are very similar. Although some people say that gold can be used for industrial refining, I am sure that 90% of people who buy gold do not buy it for its industrial use. In the final analysis, they just "expect the next person to pay a higher price to buy it from you." In fact, although it is not a Ponzi scheme, it can be regarded as a kind of Ponzi economics. There are many such Ponzi economics in the world, including pension funds and medical insurance in various countries. They are all economic mechanisms that are essentially unsustainable but rely on future generations to support their predecessors.

Back to the topic, what is cryptocurrency? There are tens of thousands of coins in the cryptocurrency market. If we only talk about some of the larger ones, there are at least hundreds of them. There are Game-fi, Web3, and even walk-to-earn cryptocurrencies. However, this article only intends to talk about the two most important cryptocurrencies: Bitcoin and Ethereum.
The status of these two in the cryptocurrency market is already unbreakable. As the first cryptocurrency and the leader of the blockchain or cryptocurrency market, BTC has been heard of by most people who are completely unfamiliar with blockchain. Its leading position is self-evident. When people mention Bitcoin, they always use its scarcity and limited issuance as the basis for its value. Of course, the price of an item in economics is always determined by supply and demand, and this statement is certainly not wrong. Ethereum's original economic model determines that it has no supply cap. In other words, it can be issued indefinitely. Of course, under the current PoW situation, it will have a fixed supply of about 12,000 ETH per day.

As a "currency" (although in fact Ethereum tokens are more suitable), it must have the three major characteristics of currency, namely:

1. Medium of Exchange
It can be used as a trading tool between commodities.

2. Unit of Account
The price of goods can be marked and can be divided. Some cryptocurrencies such as NFT do not have this feature because their indivisible and heterogeneous characteristics make it difficult to price transactions of other goods.

3. Store of Value
Can store "purchasing power" for the future

BTC and ETH can basically meet the above conditions, except for NFT. NFT cannot be traded as a currency because it cannot be used as a price measurement. For example, the last transaction price of BAYC#3749 on OPENSEA was 740ETH. If you want to use a BAYC#3749 to buy a cup of coffee at Starbucks, it is impossible for it to only charge you 0.00000420196 BAYC#3749 and then give you the remaining 99.999... BAYC#3749 in change. Because the essence of NFT is non-homogeneous and indivisible (ignore some current protocols claiming that they can split NFTs and other things). But apart from that, BTC and ETH do achieve the three major functions of currency. Of course, if you say that the Bitcoin you bought for $60,000 now only has $22,000, whether it can be considered a store of value is indeed worth thinking about, but there are also people who bought Bitcoin for $1,000 and its purchasing power has inflated today. Even the legal currency issued by the state can greatly reduce your purchasing power, such as the current JPYUSD.

Essentially, what will happen when society gradually accepts cryptocurrencies and adopts them in daily life?

Let’s first remove all factors, such as ETH’s Defi or the gas fee that can be used to run smart contracts, and only consider the currency factor.
Suppose there are a hundred people in a small rural village.

First, let's assume that there is no currency in this village, and everyone is bartering. Obviously, it can still work at the beginning, but later the villagers will find it strange and inefficient. For example, I planted some bananas and wanted to buy a chicken from Xiaoqing, who raised chickens, but she didn't want bananas, so the transaction between me and Xiaoqing failed. If Xiaoqing happened to want apples, and Xiaohua, who grows apples, happened to want bananas, then I can also exchange my bananas for Xiaohua's apples and then pay Xiaoqing for apples in exchange for her chickens. This situation is relatively optimistic, but for a rural society, the changes can be greater. After all, everyone's desires are different. Some people want wheat and some people want axes. There may be a hundred kinds of demands and supplies for just a hundred people. It is extremely difficult to reach a transaction. Of course, you can still trade occasionally, but the transaction costs (Transaction Costs) can annoy you to death.

Trading is one thing, but there are more troublesome situations. For example, when I was young in the village, I worked hard to plant a lot of bananas. There were so many bananas that they exceeded my needs. I ate them every day until I was full, but there were still a lot of bananas that were stored here and expired because I had no demand. When I was old and lacked labor, I was unable to plant bananas. At this time, I thought that if the bananas from that day could be kept until today, I could at least eat bananas, but the storage period of food is limited after all.

Therefore, due to the difficulties in transactions, currency finally came into being in human society. In different primitive societies around the world, from Mesopotamia in the Middle East to the indigenous people of New Guinea, there were also things similar to currency, occasionally using shells. On the Silk Road, silk was usually a kind of currency. After all, other spices such as pepper were too troublesome to carry and would expire.
Then the village evolved, this time using the characteristics of Bitcoin as a concept.

Now I ask you to imagine a situation. Suppose there are a hundred people in a small village. If there are a total of ten thousand gold coins, and the village is a closed village that does not engage in foreign trade and does not produce gold, what will happen?
The village will function normally at first. Gold coins can provide villagers with a reliable trading tool as currency. People no longer need to barter. The elderly will also save a pile of gold coins for their hard work in their youth, which is enough for them to live. But when the population of the village gradually increases from 100 to 120, the situation begins to change.

As the village grows, people start to have children, and farmers learn new techniques to increase their productivity, troubles will begin to appear. For example, Xiaoqing is the only chicken farmer in the village. She learned how to make hens lay a bunch of unfertilized eggs, which she named eggs. These new goods are very popular, so people in the village buy eggs from her. At first, the situation will be quite stable, but as the village continues to progress, the society begins to have stronger productivity. Xiaokang finds that he can use cattle to help plow the fields so that his planting range can be wider. As a result, because of the improvement of farming technology, the output has increased greatly, and some people can no longer engage in agriculture or animal husbandry. A smart young man Xiaoxin invented a carriage to make transportation more convenient. The various products in the village have increased, but as a closed village, the total wealth is only 10,000 gold coins. With the continuous increase of goods, the price of goods has dropped! People used to spend one gold coin to buy a pound of bananas, but now they can buy two pounds with one gold coin.

Precisely because there will be no inflation and no one will produce gold coins, and because goods continue to increase, people's gold coins are more valuable than before. What will happen in the countryside at this time?

A little Jie who is very good at arithmetic found that as long as he does not spend today, the gold coins he holds will be more valuable tomorrow! He originally planned to buy a carriage worth 100 gold coins today to transport goods, but he found that the carriage makers were making carriages faster and faster, and more and more people had carriages. The price of carriages was lower every day than yesterday, so he decided to save the gold coins and buy them tomorrow.
Humans are selfish after all. When the first person discovered that he could have higher purchasing power in the future if he saved his gold coins, Xiaojie even expected that as long as the commodity continued to develop in this way, his 100 gold coins would be enough for him to not have to work anymore! The rural population increased again, technology also kept changing, and more commodities came out. The productivity of the entire rural area was higher every day, but the total amount of gold coins in this village never changed. The 10,000 gold coins (total wealth) originally meant that each person in the village had an average of 100 gold coins, but when the village became 200 people, it became only 50 gold coins per person! In addition, when some old people dug gold coins under the tree but died before they could spend them, the gold coins were lost again. The currency of the entire society continued to decrease while productivity increased.

This is the phenomenon of "deflation" in economics. Is this a good thing? Absolutely not. Deflation will cause everyone to stop spending and keep the currency. The operation of the economy depends on social consumption and money keeps running. At this time, society will enter another stage, that is, the rich decide to keep their money at home and not spend it, hoping to buy cheaper goods tomorrow. When more and more people in society think this way, no one will produce, which will reduce the productivity of the entire society. Everyone will hold gold coins at home and wait for "financial freedom" tomorrow! Because no one consumes, the poor will become poorer, and the fruits of their hard work will become no one to buy (because the demand in society has weakened).

This situation can be roughly applied to Bitcoin. When I first heard that the supply of Bitcoin was limited, my first reaction was "Then the first people to buy it will get the biggest bargain!" Indeed, we have all heard that many people have become rich by investing in Bitcoin early, and many cryptocurrency tycoons have become financially free because of a single decision. However, this may not be a good thing for cryptocurrency or even blockchain, especially for many people like the elderly in rural areas who have lost their keys, making the actual supply of Bitcoin in the market less than the 21 million initially envisioned. These situations will only become more and more common. Everyone knows that key handling is very troublesome and can be easily lost.

When people in the whole society see that Bitcoin is becoming increasingly scarce, then everyone will only buy it for "value storage", put it in cold wallets and then throw it into bank safes to wait for financial freedom, but correspondingly, fewer and fewer people use Bitcoin to trade, and dozens of Bitcoin whales are waiting for Bitcoin to become one million US dollars each. The total 129,699 Bitcoins held by MicroStrategy will be worth 130 billion US dollars. Seeing someone getting rich out of thin air, will anyone still be willing to use Bitcoin?

I am not making a judgment on the upper limit of BTC's price, but I do think that Bitcoin will be used less and less because of its scarcity, becoming more like gold and becoming something like a reserve currency. However, if an economy relies entirely on something like Bitcoin as a currency, it will limit the productivity of the economy, because Bitcoin is limited. Even if Bitcoin is regarded as a reserve currency, it will also limit the ultimate economy of the society. After all, to a large extent, the economic growth of various countries is positively correlated with their M2. When the overall wealth of the society is only so much, then even if the society produces more things, it will not increase wealth, and only cause deflation.

Deflation sounds like it’s as bad as inflation, but it’s not necessarily true. Most people (including me) have never lived in a society with a highly tight monetary policy, but in 1980, Paul Volcker, then chairman of the US Federal Reserve, raised interest rates to 20%, shrinking the monetary policy of the entire society to the extreme. At that time, buying a house or a car required a 20% interest rate (simplified interest rate, the actual interest rate depends on the situation), and depositing money in the bank had an annual interest rate of about 10%. Rich people didn’t have to do anything but put their money in the bank, and the interest collected each year was enough for them to live. Who would innovate and work in this way?

If we replace this village with the economic model of Ethereum, it is actually not much different from the current currency. This depends on what the Federal Reserve (central bank) of Ethereum will do. For example, it will be transformed into PoS in the future, and the daily new supply of ETH will decrease. If the supply decreases, assuming that the demand remains unchanged, it will certainly push up the price of ETH. However, this is a very profound knowledge. How much should it be reduced to avoid deflation? There is no absolute answer here, and I am sure that no economist in the world can answer it, because there are many factors affecting this, including the number of users, popularity, ETH's usage scenarios, future markets, etc. Even the Federal Reserve, a central bank with so many top economists, cannot keep the United States at a moderate interest rate/currency issuance rate to balance unemployment and inflation rates. But we have all experienced how expensive the gas fee of Ethereum is when NFT is prevalent. If the price of Ethereum reaches $100,000 per coin, and the gas fee is 0.01 ETH each time, it will be $1,000. This situation is unsustainable and will only cause Ethereum users to switch to other alternatives such as layer2 or public chains such as Near/Avalanche/Solana/Atom.

As an investor, you should never blindly follow some KOLs who say "BTC one million! Ethereum one hundred thousand!" Instead, you should think about various possibilities based on normal logic and economic perspectives. Compared to listening to KOLs' calls, it is most important to read more different books to broaden your horizons.

This article aims to briefly describe the differences between BTC and ETH from a currency perspective. The actual price can be extremely irrational, for example, Dutch tulips can be so expensive that one can bankrupt a family, but madness is unsustainable, and the party will end one day. The situation of ETH is different, because it is not only a currency, but also a network token. In the blockchain world, anything can happen. For example, the gas fee can be greatly reduced after the conversion to PoS, and the supply of ETH will also decrease. As an emerging revolutionary technology, blockchain has various changes that are unpredictable. Once again, the economic theory of this article is just a simple and not completely correct description of the situation of BTC and ETH as currency, and does not take all factors into consideration.

This article does not make any judgment on prices, nor is it investment advice. We advise everyone to invest prudently according to their own circumstances. Cryptocurrency involves extremely high risks and can be lost at any time. Please understand it before making your own choice.