Bitcoin: History and Valuation (Obverse and Reverse)

We have recently reached another all-time high for Bitcoin, followed by a large drop in its price. What does it really mean? Follow me on understanding the journey that led us to this moment, which might help us to decipher Bitcoin’s different layers, and understand what is happening on the network right now.

In this analysis we will look at the two sides of Bitcoin, borrowing the titles for each section from the numismatic nomenclature: the obverse and the reverse. Here the obverse is represented by the historical analysis of the improvements leading to the development of Bitcoin in an attempt to illustrate the value added by the technology. The reverse is where the face value of a coin lies, and it is where I will attempt to understand what factors could influence Bitcoin’s valuation.

History – the obverse

The Bitcoin client software was released on January 3, 2009, and it was the prototype of a breakthrough type of innovation which many would attribute to the stroke of a single genius, a mysterious character who has chosen to keep his identity private. In my point of view, this story is better seen through the lenses of a collective effort for which the origins can be traced back several decades. To understand Bitcoin’s value proposition properly one must travel into the past and visit some concepts and people that were key to shaping it.

Cryptography is well documented in Greek and Roman warfare, and is believed to be as ancient as the written word: some characters in clay tablets containing a recipe for pottery glaze were replaced by unfamiliar ones, which could represent an effort to conceal the data from outsiders [1]. A great deal of development was achieved by middle eastern scholars between 700 and 1300 AD applying statistics and mathematics to cryptography. Nevertheless, all methods used since the classic world up until the second world war shared one major flaw: the fact that for a code to be used, a key should be shared between the participants, and this key could be captured by enemy hands in the process.

The single, greatest breakthrough in the science of cryptography happened fifty years ago and it is the development of public-key cryptographic encoding. Public key cryptography was made widely available with the publication of Diffie and Hellman’s paper in 1976 [2], and it provided a mechanism where, due to a mathematical relationship, the key could be split into one part that is made available to all users beforehand and a paired part which is not shared, enabling encrypted messages to be sent without risk of the key being captured. Nowadays we daily employ commercial level cryptography that is virtually undecipherable: trying to do so by brute force (attempting multiple combinations to find the key) would require an amount of time of astronomical proportions, even with all the most sophisticated available hardware combined [3].

There is another important use of public-key cryptography which is even more relevant for cryptocurrencies, that is the proof of authorship. Because of the paired key relationship, on a network where participants are identified by their public key, anyone could use their secret key to prove that they are the author of a specific message, and this is immediately verified by all. This is the technology that enables secure use of internet links (HTTPS) and encrypted messaging (such as Whatsapp), among others. In the cryptocurrency space, this allows for the issuance of digital I-owe-you (IOU) messages which are exactly what constitute the transactions on a network.

After the development of public-key cryptography, the idea of bringing this innovation to financial transactions began to take form. Publications in the eighties by David Chaum are referred to as an inspiration source for many other researchers that followed, in different fields of science, such as mathematics, cryptography, and software development. Many enthusiasts found themselves interacting in a mailing list called Cypherpunks, which was popular in the ’90s. Mr. Chaum himself tried to launch his Digicash technology in 1990, which offered anonymous transaction infrastructure to commercial banks, but failed to achieve meaningful commercial adoption.

In 1991, Haber and Stornetta published a paper [4] that would define blockchain technology, without however using this name. The technology consisted of a public repository of information that would add blocks linked to each other by cryptographic proofs, which would be verified with public time-stamping. This meant the creation of a time registration service for public documents or digital signatures of private documents. The researchers launched this concept as a service in 1995 through the company Surety, publishing the digital signatures of each block in a traditional newspaper and crafting what can be considered as the world’s oldest active blockchain.

In 1997 and 1998 both Wei Dai and Nick Szabo would discuss visions of a digital economy based on smart contracts and some form of digital currency that could be programmable. Mr. Szabo published a piece in 2005 proposing a digital cash equivalent by the name of Bit Gold, which used proof-of-work as a measure of value. Bit Gold held many similarities with what would become Bitcoin but was never implemented. Mr. Dai’s vision was credited as influential to the creation of Bitcoin, being included as a reference in Bitcoin’s seminal publication.

Also, in 1997 Adam Back published the first draft of what would become his technology to prevent fake messaging in a network, summarized in a paper in 2002 [5]. Within his framework, named Hashcash, each sender would need to perform a computing-intensive task for its message to be considered valid. This technology was sold as a service to email providers and it became an important tool to fight spam. In 2004 Hal Finney would find a mechanism to preserve, in subsequent transactions, the computational work done by the proof-of-work mechanism developed by Mr. Back.

Mr. Back and Mr. Finney’s developments were important steps that paved the way for the development of a digital cash infrastructure. Nevertheless, there were still pieces missing from the puzzle. Those missing pieces would finally be found in 2008 with the publication of “Bitcoin: a peer-to-peer electronic cash system” [6], which came signed with a pseudonymous: Satoshi Nakamoto. The white paper would add three mechanisms that allowed Bitcoin to become the first successful digital cash implementation.

First, it would solve the problem of double-spending in a decentralized cash network using proof-of-work and an ingenious mechanism to allow global network consensus. The double-spending problem can be understood as someone issuing more than one digital IOU for the same amount of currency owned, and it is a concern for systems without a central validator, where there is no central storage of knowledge to validate the transaction data from. In Bitcoin, the chain of data with the longest number of blocks (i.e. the greater intrinsic sum of work) would be considered the valid chain and would serve as a reference for the whole network. The successful implementation of this mechanism would become known as the Nakamoto Consensus.

The second problem faced by a digital cash network is the initial distribution of assets. If those assets are initially held by a small number of individuals, it could create perverse power dynamics. Ideally, the digital assets should be spread among the participants to preserve competitiveness on the network. The original Bitcoin software would compensate participants that provided a successful proof-of-work using day-to-day personal computers with freshly minted coins. This process, known as mining, is the single source of new Bitcoin emission and provided the initial network with an effective distribution policy based on direct participation. To prevent a large number of coins from creating inflationary pressure, the number of minted coins was programmatically set to be halved every four years, or 210 thousand blocks, with a maximum of 21 million coins to be put in existence.

This distribution system offered incentives for the participants to contribute to the network and earn rewards instead of working against it (those incentives were later called Tokenomics). It is possible to use proof-of-work against the consensus, trying to manipulate the ledger by forming a longer chain selecting some transactions while excluding others. This manipulation, however, would require an attacker to have at least 51% of the total computing power. This type of attack, known as the “51% attack”, is still a problem for many cryptocurrencies that rely on proof-of-work and have a small set of validators using low amounts of computation. In the case of Bitcoin, with the huge amount of processing used by the network, the attacker would be better off if it dedicated itself to producing new and clean coins than to try and reverse some transactions.

This last point can be considered one of the greatest achievements of Bitcoin software: lowering the consensus of a decentralized network to >50% of the valid votes, which is an improvement from >2/3 required in the original Byzantine General’s problem, proposed by Lamport, Shostak, and Pease in 1982 [7]. On the other hand, the immense amount of computer power that is used to secure the network is a common criticism that the Bitcoin network faces. This is not something that I will delve into, and interested readers may look into developments being made in proof-of-stake technology, which aims to achieve decentralized consensus while avoiding waste of computational power and electricity. In the next section, I will try and look into other problems involving Bitcoin, and the concerns participants should have.

Valuation – The reverse

When the Bitcoin software first was made available there wasn’t much activity in the network. The first blocks were mostly mined by Satoshi Nakamoto’s computer. It is assumed that Nakamoto might hold the access key to 1,125,150 Bitcoins [8]. However, since no coin was ever moved from the addresses that are attributed to Nakamoto, those are usually considered to be lost [9], either by accident or on purpose. Nakamoto went in complete radio silence in 2013, but if he were to return and decided to sell the coins, or someone else obtained access to its keys, this could impact the price of Bitcoin negatively because of excess supply.

But Nakamoto’s stash is not the only way to cause such an effect. In 2010, while Nakamoto was still actively maintaining the Bitcoin code, a bug was exploited that enabled billions of Bitcoins to be minted in one block. This was quickly noticed by vigilant users, and the code was updated. The blockchain was corrected by banning the irregular block, a process that would later be known as a soft fork [10]. This possibility of changes in the code challenges the characteristic of immutability that many interpret as an advantage of blockchain technology. Although chain splits and forks are part of the decentralized structure of the network and exist even in a healthy environment, some code modifications may come as part of a strategy to obtain control or manipulate the network.

In 2017 after an intense debate of how to scale the network to allow for more transactions, a group of miners used their political power to sway a significant part of the network participants to update their clients with modifications that effectively created a segmentation of the network. A new currency was created which would develop a value of its own. The objective of the move was to remove the control of the code from the hands of the current developers and centralize the power in a single business group, but it was not successful in convincing the majority of users, as they remained with the previous chain, which therefore kept most of its original value.

This process illustrates how easy it is to create a copy of Bitcoin and the vast number of similar cryptocurrencies are currently a problem. Bitcoin’s original code was intentionally open source, to align with the motto “don’t trust, verify”, which would become a very important principle of the blockchain community and one of the few distinguishable factors of good projects from bad projects. On the other hand, the open-source code allowed anyone to copy it and launch similar projects. Some projects caught niche attention or changed some characteristics in a manner that pleased some specific group of people. For a while, those copies were a breeding ground for innovation (some still are) and for testing new technologies that would later be adopted by Bitcoin itself.

But the number of copycat projects started to become a concern as they can undermine the original network in two major ways. They can be used to effectively overcome the anti-inflationary measure of having a fixed cap on Bitcoin supply since by providing the same service users might acquire other similar tokens, and when all are taken into consideration the supply is infinite. Copycats can also undermine the public’s confidence in the technology if they are badly maintained or designed, or if they are blatant fraud schemes. The community’s motto “don’t trust, verify” works only for some people, capable of auditing computer code and understanding financial incentives and risks. By not having a central source of trust, the cryptocurrency environment became a minefield of pyramid schemes and worthless projects, oriented at making money fast at the expense of the overconfident investor.

This challenges another characteristic attributed to blockchain technology, that it is an intrinsically safe environment for transactions, and has pushed many uninformed participants to lose money, to different degrees. The truth is very far from what is perceived: blockchain allows for the code to be audited when it is open-source, but that does not mean that all code has been audited.

But the greatest risk of dealing with Bitcoin, in my opinion, and the same goes for many other cryptocurrency projects, emanate directly from the ideals of anti-government and anti-establishment that lead to the development of the network in the first place. Much of the technology that is developed using blockchain remains unregulated in many countries, and as such, the participants are not qualified for support from laws and institutions. This lack of regulation leaves the user hanging without anyone to turn to when bad things happen.

It can be seen even at the most basic level of use: over the years I have received several calls for help from people that wanted to recover lost keys to cryptocurrency assets or to revert a wrong transaction, some even offering high rewards. To all of those, I would answer, sadly, that there was nothing to be done since many errors in the use of the network are irreversible. This lack of customer support is a characteristic of the decentralized paradigm, yet it is not clearly stated to the new users and shows how far this technology is from public adoption in its current form.

But lack of regulation can lead to even greater problems, such as unsafe financial structures that may implode when faced with adversities. The size of the market for all cryptocurrencies is a small fraction of the world’s financial markets combined, and Bitcoin is under constant manipulative pressure. The original idea of fairly mining coins with personal computers, distributing both wealth and voting rights on the future outcome of the network was supplanted by a highly concentrated structure where the manufacturers of mining equipment control the majority of the voting rights and therefore hold immense political power over the network.

The governance of the Bitcoin network has become further complicated by the role of the exchanges, which act as gatekeepers of new users entering the network, or for those that wish to leave it, permanently or temporarily as day-traders. Users needed a way to convert cryptocurrencies to central-bank-backed money, or at least to something that could approximate its value. Due to the negligence of traditional banking which denied exchanges access to local currencies, new tokens were developed called stable coins which would track real-world currencies such as the US dollar.

One such stable coin project, named Tether (USDT), now holds in its balance sheet almost 70 billion dollars [11], which places it as one of the 50 largest banks in the USA. With a major catch: it is not a bank, it is not regulated by any monetary authority, and it provides no guarantee that users can have their real-world assets back in case of a bank run. It is not proven that Tether has enough cash reserves to back up all tokens in circulation. Tether shares ownership with one of the world’s current largest exchanges, and there is suspicion that both companies could coordinate in unsafe financial practices, such as emitting coins without backing, buying and selling Bitcoins front-running users, and manipulating the market. One indication that there might be something strange with Tether is that their emitted stable coins are seldom redeemed for real-world currency, as would be expected in a healthy market. If it is the case that there is wrongdoing, then we might be witnessing a financial bubble that is bound to hurt not only people’s savings but the technology itself.

It is important to note that I am not stating that Bitcoin is in itself a financial bubble. In my view, it has value as an innovation that is still being developed. The correct level of price is, on the other hand, much harder to gauge. If one were to employ traditional financial analysis, then we would probably conclude that Bitcoin has no value as an investment, as it does not offer dividends or any form of rent, and has no guaranteed terminal value [12]. Nassim Taleb, of Black Swan’s fame, published a short paper [13] concluding that, as a speculative asset, it should have no value at all since it will always have the probability of being discontinued (its future price trajectory has random movement with a sticky barrier at zero) and there is no other use for the token outside of the network. And if Bitcoin is seen as a means of exchange, then its value is not significant, and it could be any arbitrary number as long as it is stable.

Bitcoin is, at the same time, a technology that offers a means for a peer-to-peer transaction, a communication network [14], and a token of this same network. It could be helpful, when trying to assess the value of Bitcoin, to split the analysis into those three characteristics. As a technology, especially an open-sourced form of technology, the value comes not from what it enables users to do, but by how active the community of developers is. And albeit all the governance issues listed above, the developer community on Bitcoin is very active and participants take a stake in the network, with companies like Blockstream being created to organize the development flow and promote future goals. Yet, since Bitcoin is not a share of those companies, it does not offer revenue sources from their profits, nor participation in their equity.

Bitcoin is also a token needed to employ its network, and from this aspect, it can derive a direct source of value. For many years Twitter was considered to be a special case of a company, that had no clear source of revenue, yet was able to obtain a significant amount of investment. The value of Twitter was measured by the number of participants actively using it every day. Yet, there is a significant difference between Twitter and Bitcoin, as in the latter case there is no institution that owns the network. The development team holds the key to the source code but the miners have the voting rights, and there is a conflict of interests between the two parties.

Still, there is no way to transact in the Bitcoin network without Bitcoins. This creates a demand for the token as long as there are people interested in using the network. Today, the main use of Bitcoin seems to be the transfer of large amounts of money, anywhere in the world, in a short time frame. Much of Bitcoin use is still tied to illegal or unregulated activities, even if the network is possibly the worst candidate for this. Law enforcement units worldwide are learning to read the transaction logs and the amount of Bitcoin seized is growing by the day. Also, financial sector authorities are watching the cryptocurrency environment closely, crafting new regulations to make sure that this technology will not allow for money laundering and promoting funding for terrorist organizations. Without a licit real-world use for Bitcoin, the token value of the network should decrease, not increase.

This leaves us with one final line of analysis for Bitcoin valuation: collectible value. As the property of a Bitcoin is easily recognizable, since the holder can use its keys to sign public messages attesting its possession even without moving a single coin, there is status value to holding the token within the community. A clear reflex of this can be seen in the non-fungible token’s (NFT) market which is booming recently, with digital art being sold within this format for millions of dollars in traditional auction houses like Sotheby’s [15]. Bitcoin in this sense is the original NFT, and holding one original Bitcoin token might be the modern analog of having 1/21 millionth of the Mona Lisa. How much is it worth? Well, this is a whole different scenario. It depends on investors’ appetite and the overall global economy. Works of art, even those that have historical values are not always a safe haven and many have been sold at a fraction of their previous values during a financial crisis.

Conclusion

Bitcoin value remains highly speculative and it is my view that it has no intrinsic property as reserve of value. It is known that Isaac Newton invested in the South Sea Company in 1720 [16] when many smart investors such as himself knew fully well that it was a bubble, probably because he could not be left out of the action, with such high price movements. Unfortunately, the father of calculus miscalculated and had the bubble burst in his lap.

If you chose to participate in the cryptocurrency market, I suggest you make a real investment and acquire education, in computer programming, finance, and communication networks. Then you can select the token for the technology that better suits you, knowing very well that many of those tokens are not securities and will not assure you any revenue, but might offer some other value such as network participation or as a collectible. I remain an enthusiast of the technology and intend to continue researching it, and searching for real-world applications, providing feedback, and educating other people. There is much-untapped potential, and much is yet to be discovered. Fortunately, or unfortunately, what will hold value in the future is probably much different from what has value now, and this is what makes this space so dynamic and interesting. I hope you all can enjoy the ride.

References and notes

[1] Kahn, David, 1996. The Codebreakers: A Comprehensive History of Secret Communication from Ancient Times to the Internet, Revised and Updated. Scribner. New York, New York. 1996.

[2] Diffie, W., Hellman, M. e., 1976. New directions in cryptography. IEEE Transactions on Information Theory 22, 644–654.

[3] A fascinating video on the security of 256 bit cryptography was published by the channel 3Blue1Brown on Youtube.

[4] Haber, S., Stornetta, W.S., 1991. How to Time-Stamp a Digital Document. Journal of Cryptology 3, 99–111.

[5] Back, A., 2002. Hashcash – A Denial of Service Counter-Measure. 1–10.

[6] Nakamoto, S., 2008. Bitcoin: A Peer-to-Peer Electronic Cash System, available in several languages.

[7] Leslie Lamport, Robert Shostak, and Marshall Pease. 1982. The Byzantine Generals Problem. ACM Transactions on Programming Languages and Systems 4, 3 (July 1982), 382–401.

[8] Source to Satoshi’s coins.

[9] It is estimated that around 20% of minted Bitcoins are lost by people that don’t have access to keys, or that have sent them to the wrong address. Nakamoto’s coins are usually added to this pool. Exclusive: Nearly 4 Million Bitcoins Lost Forever, New Study Says (FORTUNE)

[10] A fork has its name because it splits the path of code development. When a fork is imposed in the network, and the changes cause updated clients to be incompatible with previous versions, it is known as a hard fork. A soft fork will change the code and make it still compatible with previous versions. The blockchain consensus had to be temporarily changed to avoid including the problematic block, and most participants updated their clients to be able to skip it. Once a new consensus is confirmed by establishing the longest chain, then older versions of the code would naturally turn to the new chain, even without updating.

[11] Anyone Seen Tether’s Billions? (Bloomberg Businessweek)

[12] In the fifth edition of Berk & DeMarzo’s “Corporate Finance” textbook a section is dedicated to discussing possible valuation metrics for Bitcoin with a similar take away. (ed. Essex: Person Education Limited)

[13] Nicholas Taleb, N. (2021). Bitcoin, currencies, and fragility. Quantitative Finance, 21(8), 1249-1255.

[14] Andreas Antonopolous in his book Internet of Money defined financial transactions as a mean of communication, and transaction in Bitcoin network are text messages publicly posted to every participant. This is why all the transactions can be traced back at each step up to their origin.

[15] Sotheby’s Enters NFT Digital Art Market, Considers Broader Cryptocurrency Options (The Wall Street Journal)

[16] Odlyzko, A., 2019. Newton’s financial misadventures in the South Sea Bubble. Notes and Records: the Royal Society Journal of the History of Science 73, 29–59.

Felipe Van de Sande Araujo

Felipe Van de Sande Araujo is a PhD candidate at the Department of Industrial Economics and Technology Management