How Cryptocurrency Bitcoin Value Can Be Backed?

Is Bitcoin backed by physical money? 

This is a question many new entrants, unaware of the hows and whys of the Crypto Sector, often ask themselves. Red-faced advocates, scrambling for answers, grapple at notions such as scarcity (“There will only ever be 21 million bitcoins in circulation”), which, as we will see below, do not provide strong enough answers to this question. The question itself is interesting, as it mixes a digital asset emblematic of value exchange in the new paradigm we find ourselves in, and an asset emblematic of value exchange in the old paradigm.

The answer to this question (“What is Bitcoin backed by?”) would be extremely obvious if Bitcoin had decided to go the way of USDT. “It is said” that Tether is backed by real reserves of US dollars. Therefore the problem of Tether’s value is solved in a very pragmatic way - one USDT equals one dollar - more or less. There are a few other cryptocurrencies which are backed by real assets, USDT is obviously important due to its 62 billion USD market cap, however let us not forget the Paxos Golds, the Meld Golds and the Digix Globals of this world (the last three are backed by real reserves of gold).

Bitcoin, as you may know, is not backed by a real-world currency, not even by a basket of currencies or commodities.

“Bitcoin and its blockchain technology is a form of dematerialised money, a pure token devoid of any connection to an underlying material substance, money created ex nihilo, and as simulacra without reference to the real.” (Baldwin, J. In digital we trust: Bitcoin discourse, digital currencies, and decentralized network fetishism)

Bitcoin is not pegged 1:1, as in the case of stablecoins, with other assets either. Bitcoin breaks the need to even reference real world assets. Realizing this further complicates attempts to provide a clear answer to the question and therefore determine Bitcoin’s value, or rather, what Bitcoin’s value should be outside of raw price discovery.

The usual argument provided to answer the question of Bitcoin’s value is the argument of Scarcity, which we will review below. We will ignore here the arguments of Consumer Confidence (Bitcoin is valuable because we believe in its value), and also the arguments of Divisibility, Transferability and Utility (Bitcoin is valuable because it can be used as a currency in various contexts), which are used in conversation to support the argument of Scarcity.

Bitcoin is scarce by design. It was “pre-established” (Christopher 2016, p. 172) at Bitcoin’s inception that there would only be 21 million bitcoins. 18.5 million bitcoins have been mined so far, which leaves us with approximately 2.5 million bitcoins left to be mined, at different rates, if we consider fluctuating network difficulty, global hashrate and halving events. The demand for Bitcoins, as we have seen recently, is trending up due to (among other things) increasing retail and institutional demand. All indicators, including price, point to this fact that demand is increasing. And therefore, bitcoin advocates conclude, the value of Bitcoin, following classical market dynamics, is driven by scarcity.

However, the argument of scarcity truly doesn’t help us see or understand what backs Bitcoin. The argument of scarcity provides a portrait of a currency that is backed by exactly nothing, but is valuable due to classic scarcity dynamics driving the price.

To understand what backs the value of Bitcoin, a change of mindset is absolutely required as we are not dealing with a traditional asset that can be explained away with classical theory.

We can all agree that Bitcoin is a new, immaterial form of money, which does away with the need to trust central authorities and financial institutions. However, as much as we would like to throw Trust out with the bath water, Trust cannot be eliminated altogether. In our new paradigm, the Object of Trust is displaced. What we now trust is the algorithm, the code:

“One must simply trust the code, or, more precisely, the cryptographic algorithm.” (Maurer et al., 2013, p.264), the “algorithm that governs user’s interactions” (Hawlitschek et al. 2018, p. 57), the “Open Source Code” (Atzori 2015, p. 7).

The Bitcoin code is implemented to create Trust in a Trustless environment “by computation” (as Andreas Antonopoulos would say) or what Linkedin co-founder Reid Hoffman calls: ”Trustless Trust”.

Therefore, we would like to advance this thesis, which will appear rather controversial to outsiders clinging to traditional notions characteristic of classical theory, but will make complete sense to insiders who instinctively know this to be true, that bitcoin is backed, not by real assets, but by its Algorithm, backed by code, which allows the network to generate Trust in a Trustless environment. The Value of Bitcoin is derived by the value of this Algorithm:

“Bitcoin is a promise underwritten and backed by an algorithm and its manifestation in a digital peer-to-peer network.” (Maurer et al., 2013, p 274)

Having said this (Bitcoin is backed by an algorithm that allows the creation of Trust in a Trustless setting, and its value is derived from the value of this algorithm), we can answer a few questions regarding Bitcoin’s value such as: will it ever become worthless? Is Bitcoin a bubble?

Bitcoin provides a strong (perhaps the strongest) alternative to Trust in centralized systems. Bitcoin as a network allows the “displacement of Trust” from centralized entities to a decentralized network of machines that work in concert to produce “Trustless Trust”. It is clear that as long as individuals distrust centralized entities and demand alternatives such as Bitcoin, then Bitcoin as a technological proposition and as a solution will continue to have value.

The idea that Bitcoin is a bubble ready to burst (3 in 4 professional investors seem to think so) stems from the fact that commentators rely on classical valuation techniques to describe an asset that defies any explanation emerging from the traditional paradigm of asset valuation. After years of predictions of a crypto market crash - the mother of all market crashes - we need to come to the conclusion that the concepts that we use to describe and discuss Bitcoin cycles need a revamp. As we have seen above, what mainly drives Bitcoin’s value is not its Scarcity, Divisibility, Transferability or Utility, and certainly not mere market dynamics or price discovery, but rather the intrinsic value of the algorithm that makes Trust possible in a trustless setting. The price of bitcoin which reached a high of 65 000$ US dollars in April of this year, is a testament to the fact that, as the Bitcoin Network expands (currently there are 64 million wallets in existence), Trust in Bitcoin’s algorithm and therefore the value attached to it grows as a direct function of User Growth.

Final Thoughts

The notion that Bitcoin is backed by “something real”, such as a real-world currency or a commodity needs to be eliminated from the outset. However the idea that Bitcoin is a digital asset “backed by nothing” that derives its value from pure price discovery has to be put aside as well. Bitcoin is backed by its Algorithm, and its value is derived from this mind-boggling feat of engineering which creates Trust in a decentralized setting.