Down the Bitcoin Rabbit Hole
Chapter 2: Limited Supply
It’s been some week. As I write this, we still don’t know who will occupy the Oval in January. Lawsuits are already beginning to fly. Honestly, as I discussed in detail yesterday, I think the key is a split legislative branch. With a R Senate and D House, there is going to be gridlock in DC, which is exactly what investors love. The chances of a big, sweeping, dramatic change taking place are smaller. Risk assets are moving higher and we will see if this remains the case.
Last Friday, I wrote about Bitcoin and was not surprised that it was one of the most read notes that I have published so far. In that note, I called bitcoin the “ultimate hard asset.” This is because there will only ever be 21 million of them in existence. Contrast that with the US dollar which the Federal Reserve can print more of whenever they need. Basic Econ 101 question: When the supply of something is theoretically unlimited, what is it worth? The same goes for the ECB and the euro and the BOJ with the yen. In fact, the Bank of England is taking action this week to head off the implications of another round of lock-downs due to COVID.
The question is where does the bitcoin come from? The best thing to do (which has helped me understand it) is to think of it as digital gold. Just as there are people who use machinery to mine gold, there are people who use high-powered computers to mine bitcoin. Here is what the team at Investopedia has to say on it:
Bitcoin mining is performed by high-powered computers that solve complex computational math problems; these problems are so complex that they cannot be solved by hand and are complicated enough to tax even incredibly powerful computers.
The result of bitcoin mining is twofold. First, when computers solve these complex math problems on the bitcoin network, they produce new bitcoin (not unlike when a mining operation extracts gold from the ground). And second, by solving computational math problems, bitcoin miners make the bitcoin payment network trustworthy and secure by verifying its transaction information.
Translation: people with really powerful computers use them to solve really complex math problems. Their “reward” for solving these problems is…bitcoin. Go back to the gold example and it makes sense: a company uses complex machinery to dig deep into the earth. Their reward is the gold that they find.
The reward to bitcoin miners every time they solve a problem is 6.25 bitcoin ($15,000 current price = $93,750). But here is the kicker, that reward used to be higher. For about four years before May 2020, the reward was 12.50 bitcoin per problem solved. For four years before that it was 25 bitcoin per problem. The system was designed to have the supply increase at a decreasing rate. Every four years, the reward is halved…it’s called a halvening and the next one will be sometime in 2024. It is designed to be deflationary. Contrast that again with the US dollar, every time the Fed prints more money, they are eroding our purchasing power, our current system is inflationary.
By the way, all 21 million will be mined by sometime in the year 2140, so in 120 years. In the hear and now, bitcoin is breaking out of a consolidation and there is not much standing between it and the all-time highs. The fanatics are going to be giddy if that happens soon.
This book and this movie helped give me a good understanding of the basics. I highly suggest anyone who is going down the rabbit hole with me take a look at both.
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Every Monday - Friday, I write about the markets for clients of Chaikin Analytics. You can find out more about my process here.