Understanding Bitcoin & the 5 Axes of Power

>Summary: Bitcoin is likely to be the basis for the up-and-coming Internet of Value. Since its supply is limited, I expect BTC/USD to surpass 500.000USD in the next 5 to 10 years. The Last (Bitcoin) Supper by Youl >The 5 Axes of Power: money plays a central role in our society. The internet has decentralized almost all axes of power. Money is next with Bitcoin and other cryptocoins.

Extensive reading on the history of our civilization has led me to believe that power evolves around 5 main axes. For practical investment purposes, I believe getting a read on these and specifically their deltas (before most of the market) helps to make good investments, since they are powerful predictors of capital flows.

These axes intertwine with each other throughout history in fascinating ways. A thorough analysis would be quite long, but perhaps a brief intuitive overview will suffice, to really understand how power evolves around the world and how Bitcoin plays a role.

Consider all the science in the world, that has evolved through time. Could it have delivered value to citizens across the world without the forces of the market / money? When Mehmet Ali attempted to industrialize Egypt in the 1800s, he had enough money to buy the latest cotton spinning machines that science/Britain could output. What he did not have, was the right culture in Egypt to have these machines equate to a competitive output. They would often catch on fire and parts would go missing all the time.

Without violence, we would be better off in many ways. But we could also be living in a Nazi planet. Monotheistic religions have been arguably the most violent and simultaneously unifying of all, but without sharing deeper level believes with one another about our existence and fate, chances of cooperation are scarce. Market forces move our world and money is at the core of every single exchange. However, with no handle on violence, culture or religion, money cannot help (see the less developed parts of the world). Without science, we cannot go beyond our default monkey-level existence, no matter how much money or great a culture we have.

When these 5 axes align, we produce prosperous societies. Perhaps not so obviously, the internet has profoundly altered this schema in the past 20 years, in the way each axis functions. Communication is at the core of everything we do and the internet has fundamentally decentralized our communications matrix. Cutting edge science (e-learning etc), the latest advancements in culture and religion (Instagram), are all available at the click of a button, whilst violence remains a governmental monopoly. It has made the flow of information freer and has given rise to many different phenomena.

This has notably fragmented and polarized our politics, for instance. It has also democratized education (previously a functional monopoly). It has given rise to the cancel culture, powered by a swarm of cybernauts in different platforms unconsciously driven by cunning algorithms. It has turned chess into a far more popular sport. Most notably, it has turned us into a data driven society, because now the 5 axes of power are essentially data producing machines, since they are increasingly digitalized.

Little needs to be said about how the internet has change our lives. Trillions of dollars of value are built on it. Currently, most of the value is built around information arbitrages and the core underlying functionality is a cheaper, faster and more decentralized information flow, as compared to previous methods (carrier pigeons, phone etc).

Cheaper, faster and more decentralized value / money flow is next in the form of a range of internet-native cryptocurrencies. In the current version of the internet, we are exchanging information with one another. However, we are transacting value outside of it, in currencies that are not native to it. For this reason, transactions depend on third parties and this makes the flow of value slower and more expensive than it could be otherwise.

Careful study of blockchain technologies (at the code level) has revealed to me that Bitcoin is in essence secure internet gold, that does not depend on third parties and that serves as the basis for a second internet — “The Internet of Value”. It is a decentralized network of value. A kind of Facebook for money if you will. The evolution of Bitcoin is the internet decentralizing, in plain sight, the arguably most fundamental axis of power in our civilization. When the first internet started (the information one), it looked like a toy to most of us. This observation is one to meditate on.

The internet of value is likely to follow a similar path to that of information. It will enable more freedom, efficiency and democratization — much value is likely to transacted within it and built on it. It is also likely to bring about personalized monetary policy through programmable money¸ when central banks digitize FIAT currencies in a few years. This will have its own yin and yang.

>Understanding Bitcoin: secure internet gold/money.

In essence, Bitcoin swaps the involvement of a trusted third party for mathematical truth. It does this by leveraging maths, computation, decentralization and behavioural finance. In my opinion, it is one of the most profound engineering breakthroughs in our short history. By the end of this section, I hope you will understand Bitcoin and its underlying clockwork well.

Current State of Affairs: the financial system relies on trusted third parties.

Today, banks keep ledgers of transactions. This enables a bank, the trusted third party, to know when a customer has spent a certain amount and thus solves the double spending problem — you cannot spend the same money twice because the bank knows you have spent it already. This gives the recipient of your payment (or the counterparty in the transaction) a certain assurance. In any given transaction, there are often plenty more intermediaries (especially if the payment is done online). The bank has all the information about what we do with our money and ultimately, so does the government. This reduces the speed and increases the cost of transactions and the likelihood and ease of confiscation by “public servants”. Additionally, non-reversible transactions are not impossible, and this makes fraud a constant risk to sellers.

The New Financial Paradigm: mathematical truth, decentralization and behavioural finance.

Users in the Bitcoin network have wallets that contain coins. Each user has a public key, a private key, and a wallet address. The private key is to be kept secure since it allows the user to operate its wallet. Transactions are made public, but you can only see the public key of the transacting users. You cannot trace a wallet address from the public key, so that keeps transactions anonymous, enabling transparency at the same time. The network is composed of nodes — individual computers that provide computing power to the network.

An electronic coin, like Bitcoin, is essentially a chain of digital transactions. Each owner of a coin transfers it to the next by digitally signing (with his private key) 1. what is known as the hash of the previous transaction and 2. the public key of the corresponding wallet. This chains transactions together. For now, consider the hash to be a number that identifies the previous transaction, in the large chain of transactions that composes an electronic coin.

To eliminate for the need of a trusted third party, transactions are broadcast to the network and in turn, network participants (nodes) agree on a single order of transactions — a single chain. In this way, everyone can see the transactions that happen and a single truth is agreed on. If the agreed truth resembles reality, since transactions are visible to everyone, this solves the double spending problem. Ideally, a chain of transactions is created through time that represents truth. The longer the chain, the more it is regarded as the truth by the network participants.

You might be wondering, how does mathematical truth come into play? Hashes are the output of a costly computational puzzle. For instance, when a transaction is broadcast into the network, a miner will include this transaction in a block. When the block is full of transactions, the miner must solve the mentioned puzzle so that the resulting hash (hash = long list of numbers and letters) of the block meets a series of characteristics — like starting with 6 zeros. When he does, the block can be included into the chain. This requires a great deal of computation and thus serves as an investment into the network. The miner is basically paying for energy and hardware to include a block (a series of transactions) into the network.

This investment (known as Proof of Work — PoW) serves as the basis for mathematical truth. The computations performed to solve the mentioned puzzle are entirely random. The game consists in guessing a number known as the nonce. Passing the nonce, together with the rest of the block´s data, through a hashing function, produces a hash. The nonce is the only datapoint in the block that can be changed and so the game is all about guessing a nonce that will get you the hash you want. Decentralization turns this randomness into mathematical truth.

How? Suppose that 60% of the participants (nodes) in the network are honest and that the remaining 40% are not — meaning that they want to attack the network. How does an attack work in the Bitcoin world? Suppose dishonest node A sends 1 BTC to node B (who is a seller of some product). The transaction is broadcast into the network and dishonest node A starts working on a secret parallel chain that reverts this transaction, together will the rest of the dishonest nodes, solving all the computation puzzles for each successive block. If he can manage to produce the longer chain for a sustained period then the attack would be successful, since the longer parallel chain would be regarded as the truth.

Since computations are random, the chance that any dishonest node will validate the next block in the network follows a Poisson distribution – because at any moment in time, it is either an honest node or a dishonest node that will validate the next block. Skipping all the stats that stem from this simple principle, it basically means that odds exponentially stack up against the less predominant set of nodes. If less than half of the nodes in the network are dishonest, then odds stack up against them. In our example, honest nodes can exponentially overpower them as time goes by and create the longer chain, which will then be regarded as the truth by the rest of the network. You can now see how mathematical truth is brought about in a decentralized network.

Now, the question remains, how to keep nodes incentivized to be honest? If more than half of the nodes become dishonest, then the entire network becomes corrupted and thus its currency worthless. The solution is as elegant as harmful to the environment. Since solving the PoW computational puzzle requires a large deal of energy, it would go against the interest of miners to corrupt the network. PoW keeps miners invested, since what they get in return for mining is coins. If the network gets corrupted, then their coins lose their value. Any other protocol that keeps the decentralized network of transaction validators invested into the network will do the job (consider Proof of Stake in Ethereum). Now you can see how Bitcoin leverages maths, computation, decentralization, and behavioural finance to solve the double spending problem, circumventing the need for a trusted third party.

Nodes can join and leave the network at will. In coming back into the network, all they must do is pull the latest version of the chain by querying other active nodes. Alas, Bitcoin serves as a robust decentralized network of value exchange that works on the internet, as long as more than 50% of nodes are honest. The way the nodes communicate in the network is through a P2P protocol. There are actually a number of different kinds of nodes, that perform different functions, but perhaps that is material for a more technical conversation.

>Identifying Value: Bitcoin is a “Facebook for money”.

Since this summer, I have been thinking hard about what constitutes value in the digital space. Since it is so ethereal, it is hard to think about value in a traditional way and this I believe is the case with Bitcoin.

I invested in Spotify this August because I believed that the business opportunity that lay ahead with podcasts (a new cultural force) was tremendous (and not totally discounted by the market). Still, I struggled to frame value clearly. Spotify is basically built on a series of open-source languages (maintained by decentralized communities), by a set of employees that could pretty much create a new Spotify (the software bit, anyway) in a few months if they chose to. What stops them from doing that? And what would stop artists / users from fleeing to this alt-Spotify?

In studying Bitcoin, I have found that the answer again lies in the nature of decentralized networks. It is statistically unlikely that a majority of stakeholders of the network leave / go rogue at once. In the past 10 years we have seen this play out many times, as one network in its vertical of information arbitrage becomes the dominating brand. Employees and users stay because they get value from the network. Employees get paid for performing actions that maintain/increase the value of the network. Think AirBnB, Uber, Facebook, Spotify, Google, Amazon etc. This is known as Metcalfe´s Law, that “states the effect of a telecommunications network is proportional to the square of the number of connected users of the system (n2)”. FYI, in case you had not thought of it, these businesses are entirely built on information arbitrages.

Perhaps the above seems obvious, but since the consensus is that Bitcoin is “built on nothing”, is there any knowledge transfer that could shed some light on this topic? Firstly, the companies listed above serve a function that adds value to end users. Secondly, they build network effects that keep stakeholders invested and engaged with the network and that bring about growth. When Facebook IPOd in 2012 it was not obvious to see that they were in effect trafficking with attention. They keep users engaged in the app/s and then sell that attention to advertisers — it is an attention network. They create network effects to bring more attention-donating users and more paying advertisers and through this “simple” approach, the stock has 10Xed since then. This is the playbook of our time and it is totally transferable all over the economy.

It was quite hard to get a read on Facebook back then, but in retrospective, we have seen this same playbook unfold numerous times since. Almost every time, the consensus is that the subject of the investigation is built on nothing and years down the line the business/stock does quite well. So now, what is the difference between a Facebook employee and a Bitcoin miner? In my view, both perform actions recurrently to enhance the value of their respective network and both are invested in it. What is the difference between a Facebook user and a Bitcoin user? One sends their attention across the internet and the other sends/stores value in it. In my view, the value of Bitcoin is built in the same way as in a lot of the most successful business ventures of our time. Bitcoin is the dominating brand in its vertical. The playbook is the same. This time however, it is all about money.

>Price Drivers

Bitcoin is limited in supply: the supply base is limited to 21 million coins. Today, around 18 million have been issued. New coins are issued to miners as a compensation for their validation work, until the supply base limit is reached. From this point onwards, miners are paid transaction fees by users per transaction. This makes the price of Bitcoin a direct function of demand.

The question is, therefore, what drives the demand for Bitcoin?

Bitcoin is programmable gold: the network and the underlying blockchain technology make the store of value in Bitcoin feasible. Its dominating brand makes it the number 1 digital store of value and therefore, in the digital space, increasingly analogous to gold. The fact that it is digital makes it programmable and highly embeddable into the internet economy, unlike traditional gold. Not turing-complete, but way better in that sense than a bar of gold. BTC currently has a market cap of around 450bn USD, whilst gold has a market cap of around 10tr USD. If we are to see most of economic growth happening in the digital space in the next few decades, we are also likely to see the market cap of BTC surpassing that of gold.

Governments: today, anything is a good excuse for governments to increase control over citizens. We are seeing this in a generalized rise of censorship, amongst other fancy moves. This includes the confiscation of money, directly or indirectly (inflation through expansion of monetary base). The wealthy and/or intelligent are paying attention. Since Bitcoin is limited in supply and quite hard to confiscate (due to its cryptographic nature), it serves as an appealing store of value. Even more so if one believes that it is indeed the basis for a second internet — the internet of value.

The internet-based economy has a tendency towards self-sufficiency and autonomy. For instance, in the server-side, we have seen the rise of AWS and not the rise of an equivalent government-based server operation. We have seen people continuously getting ahead of regulation and pushing for democratization throughout, with applications that have disrupted time and time again the whining non-internet economy. There is a certain “energy” on the internet that points in a certain direction. If you review what the internet has done in the past decade with information and the way it has changed our world, what do you believe it will do in the next decade or two with (internet) money? Is it likely to not devour this axis of power?

>Seeing Through the Hypes and Woes: intrinsic network KPIs are correlated with the evolution of BTC/USD, in the mid term and beyond.

Investing in Bitcoin is fundamentally investing in a network that serves a function and that leverages a series of network effects. Seeing through the hype is seeing the network for what it is. As BTC consolidates as the go-to internet store of value, I expect the ride to be bumpy in terms of the evolution of BTC/USD and not apt for the faint of heart. Although the model of the 5 axes of power is somewhat abstract, I believe it to be the clearest mental model to see through the hype and through inevitable reversals of the hype.

For further illustration, let us inspect the evolution of BTC/USD versus some simple intrinsic network KPIs (source: blockchain.com):

Note how pricewise, BTC/USD is prone to volatility. However, the price in the mid-long term is evidently correlated with the number of wallets (people / organizations that have coins) and transactions, the same way the price of Facebook stock is correlated with the number of active users and paying advertisers. Bitcoin is a trust network. Facebook is an attention network. Today, there are around 63 million wallets on the network. There are 7.8 billion people on the planet. If the internet does choose to devour the money axis of power, one can expect the number of wallets to go up by a lot in the next few years. Currently, the growth curve looks exponential. Would 350m wallets in a few years be much of a far cry? 800m? 1.5bn?

Now, by this stage it may be clear to you that Bitcoin presents at least a mild disruption to the established order. Surely, therefore, governments illegalizing Bitcoin would represent a risk to the investment. Nonetheless, doing so would effectively imply shutting down or considerably censoring the internet, much a-la-China. Because the network is decentralized, it would be perhaps impossible to do. In such a scenario, I believe BTC/USD would go up even more, because the need for something like Bitcoin would become even more urgent. In my view, such an effort by governments would serve as one of those direct attacks to the internet economy that have turned out to act as massive positive marketing campaigns in the past decade — like Uber back in the day, but even less accessible from the “physical realm” this time.

>Technical Concerns: the network has some vulnerabilities and scalability is an issue.

PoW is Inefficient: the consensus mechanism that I have explained above, PoW, requires a great deal of energy input (see graph below: source; https://cbeci.org/). This makes it bad for the environment. I have spent a great deal of time in 2020 studying consumer preferences and I have observed that brands that have a positive impact on the environment tend to outperform those that do not. Being bad for the environment is a headwind for Bitcoin, especially when it comes to mainstream adoption. Ideally, Bitcoin must correct course to make a net positive impact on the environment.

51% attack: some miners could group together and perform a 51% attack on the network. Before diving deeper into this, bear in mind that a 51% cannot be used to steal coins. One can only steal coins by stealing the private key associated to those coins. In the Bitcoin world, a malicious miner with more than 51% of the mining capacity, as it refers to an attack, can only perform transactions and then revert them. For example, he can send 1BTC to seller B and then revert the transaction, to get the product from seller B for free.

Currently, the mining pool looks as follows (source; https://blockchain.info):

Now, since PoW involves such a large energetic input (perhaps second to the monetary input associated with the hardware to perform the mining), miners are very invested in the network. All they get in return for their input is coins and therefore, going malicious would considerably decrease the value of the obtained coins. It would be entirely possible por some organization to attempt to bribe a few large miners to get together and perform a 51% attack. However, such a briber would have to pay the miners (the total number of coins to be amassed through time * E[BTC/USD @ 2030–2040]).

Scalability: Bitcoin cannot process more than around 7 transactions per second. Current block size is 1MB and a new block is mined every 10 minutes, so the network is not very scalable. The community (all the smart people you see contributing to the Github repos: https://github.com/bitcoin/bitcoin, https://github.com/lightningnetwork/lnd) has come up with a promising abstraction, that encompasses two operational layers, as follows:

Where Layer 1 would be the Bitcoin blockchain and Layer 2 would process micro-transactions, that would be over-kill to push to Layer 1 every single time. For example, consider that Bill buys coffee every morning. Instead of pushing each transaction to Layer 1 every morning, Layer 2 would bundle these transactions and once a week, push the aggregate to Layer 1. In this way, the abstraction compresses 7 transactions to 1.

>Conclusion: the above could be entirely wrong.

Bitcoin could not be the basis for a hypothetically incoming Internet of Value. If indeed cryptocurrencies are to be the basis for this second internet, then Bitcoin may be overthrown as the go-to. However, Bitcoin currently has the dominating brand in the space. Although the technology is not perfect, enough intelligent people seem to be pushing it that we are currently seeing exponential progress in its adoption.

My first business venture was a P2P marketplace. In developing it, I learnt that whatever can happen in the internet, will happen. I believe that if internet money is now a possibility, the internet will soon exploit any possibility that can be exploited on top of it. In this sense, Bitcoin is no different to the other networks that we have seen flourish in the past decade and again, whilst there are risks, history suggests this may be another deca-bagger.

I recommend investing in Bitcoin and in the crypto space in general. Be it through the purchase of assets or through vigorously educating yourself about it. Up next, I will be exploring Ethereum. I have a feeling that it will be the world´s first global and decentralized operating system — a kind of planetary operating system.

Join Coinmonks Telegram group and learn about crypto trading and investing Also, Read Get Best Software Deals Directly In Your Inbox

Why are Platforms always done at ATH?

Crypto Whales Are Quietly Accumulating This Altcoin at an Unprecedented Rate, Says Santiment

Understanding Bitcoin & the 5 Axes of Power

So I got paid in bitcoin today. That was pretty cool