#1 - Why Bitcoin?
Credible Commitment to Rule of Law
Matt Fox - March 19, 2022
Introduction
As investors in the bitcoin ecosystem, we are acutely focused on (i) bitcoin’s becoming increasingly established as a global store of value and (ii) funding technology and companies that enlarge bitcoin’s functionality as an open monetary network. While improving the ability of participants to transact and broadening the scope of financial activity that can be accomplished on bitcoin would undoubtedly bolster its potential as a global store of value, much of bitcoin’s progress on the path to global legitimacy will come not from its own improvement, but rather its consistency. Particularly against the backdrop of a diminishing reliability of the incumbent, fiat monetary regime, the security guarantees that bitcoin offers are remarkably strong and constant. As the prospects of any investment in the bitcoin ecosystem are inherently correlated to the success and value of bitcoin, it is worth a discussion of what makes bitcoin valuable, and what it is about bitcoin that enables its potential success.
Decades of globalization, loose monetary policy, and internet-fueled growth has culminated in unprecedented levels of technological and monetary centralization. Inherent in this centralization is political capture, which erodes the impartiality of many of the institutions that individuals rely on to be mere conduits of their economic or expressive activity (from online communication platforms and social networks, to payment processors, banks, and money itself). Standing in stark contrast is bitcoin, whose fundamental success is the creation of an economic ecosystem that resists the ability of power over it or within it to centralize. These strong assurances against centralization and ultimate political capture allow users of bitcoin to enjoy ownership of their property and economic activity to a heretofore unprecedented extent. Not only are the guarantees of bitcoin categorically stronger than the incumbent, fiat regime at the outset, but at the same time that bitcoin is beginning to reach global relevance, the world is increasingly struggling with the ramifications of politicization that comes with technological and monetary centralization. The end result is a one way path of the growing disaffected and wary who appreciate the promise of bitcoin, fueling its rise to a global store of value.
What Makes Bitcoin Valuable?
One often hears that bitcoin is valuable because it is “decentralized,” but what does that mean? In reality, bitcoin is decentralized in numerous, disparate manners. Each of these vectors of decentralization is necessary for, but alone insufficient, in creating a system-level decentralization.
To summarize the above, bitcoin goes to great lengths (sacrificing computational efficiency and transaction scalability) to decentralize every major component of its ecosystem. Participation in the ecosystem is open to all, with public keys serving as a decentralized identity scheme. Owning bitcoin is reduced to knowledge of a secret, eschewing the requirement to store savings with a counterparty to ensure security. Transactions are broadcast out to the network and node software disperses pending transactions to peers. Miners are distributed across the globe and are effectively racing to guess a large random number in order to win the block reward, limiting the ability to censor transactions and serving a largely objective, economically self-interested role. The validity of the entire history of bitcoin transactions and one’s own outgoing/incoming transactions can easily be sent/verified by anyone with an internet connection and ~$150 worth of hardware. Crucially, the security of much of the system (from address generation to randomness and security of private keys, to the public auditability of the entire ledger) is underpinned by computer science and cryptography – cold, hard, objective, math.
Many advocates of bitcoin will highlight one specific vector of decentralization as the key to bitcoin’s success. To one it may be decentralized storage, which allows practical direct ownership of wealth; to another it may be bitcoin’s enforced scarcity and inability of a central bank to print more; to yet another it may be the peer-to-peer payment network capability. But interestingly, many of these individual characteristics were not novel with bitcoin. As Arvind Narayanan and Jeremy Clark say in their paper on the history of bitcoin’s technological primitives, “Nearly all of the technical components of bitcoin originated in the academic literature of the 1980s and 1990s.” They conclude that “Nakamoto’s true leap of insight [was] the specific, complex way in which the underlying components are put together.” In short, at its fundamental and most broadly applicable layer, bitcoin’s success is its system-level decentralization.
Crucially, each individual vector of decentralization relies on the others for its own integrity. For example, the distributed consensus and censorship resistance provided by proof of work mining would be hollow if all users of bitcoin needed to register their addresses with a central registry. A diverse and geographically distributed network of nodes would be meaningless if the code they ran was closed source, or if protocol and node software development were concentrated in the hands of a few. The programmatic and predictable supply schedule would be less reliable if block size and node storage requirements were allowed to get too big, as the network would centralize around a small number of nodes, and major protocol rules (such as the inflation rate) would be much easier to change due to a diminished coordination challenge. This principle is at the center of many bitcoiners’ criticisms of “altcoins” or “Web 3” - where it has become fashionable to say that different levels of decentralization are sufficient or required for different use cases. When a blockchain sacrifices distributed consensus for transaction throughput, or allows the blockchain to become so big that it centralized the number of full nodes, it weakens every other vector of decentralization. Without strong system-level decentralization, it is a question of when, not if, the centralization of one vector will spill over to the rest, leading to political capture.
An appropriate parallel can be made to the United States Constitution, in that it was also an innovation characterized by the creative application of existing concepts (representative government, separation of powers, and federalism in the U.S. Constitution’s case) to create a system that could, to a greater extent than anything prior, resist the centralization of political power. The similarity is not coincidental, and in fact many of the principles underlying the U.S. Constitution are present in the “governance” design of bitcoin. For example, the concept of higher (constitutional) and lower (legislative) law is present in bitcoin with non-backwards compatible hard forks. In the same way that changes to the Constitution require a higher consent level than simple legislation (2/3 majority in the House and Senate, as well as 3/4 of state legislatures), changes to fundamental rules of the bitcoin system require a hard fork, which means the change can only be actively accepted by downloading the new software, while old software will consider the new blocks invalid (resulting in a fracture and two separate ledgers, from that point forward). Similarly, bitcoin enlarges a portion of the separation of powers in the Constitution, by unbundling the legislation and ratification processes. While Congress writes and passes law (and are loosely held accountable through periodic elections), software developers can only write software updates for bitcoin, while it is ultimately up to each node to “ratify” the proposed update. Open source code and multiple software implementations further diminish the power of any one team of software developers over the direction of bitcoin.
These measures are crucial because they strengthen the rule of law, the credible commitment that all participants are playing by the same, equally applied, rules. The U.S. Constitution was special because it did a better job than anything before it at limiting the surface area of human governance, and of preventing the centralization of control over that reduced surface area. The resultant political system proved a boon to its citizens and civilization broadly, by unlocking a greater portion of individual capability. In the same way that the U.S. Constitution represented a world-historical strengthening of the credible commitment to rule of law in political life, bitcoin represents a world-historical strengthening of the credible commitment to rule of law in economic life.
Put another way, bitcoin provides the strongest rules-based economic system ever known to man. It does this by replacing legal promises interpreted and deliberated on by humans (lawyers and judges), and ultimately enforced by other humans (police, governments) who have a monopoly on the legal use of force, with mathematically verifiable promises enforced by computational difficulty. As a result, bitcoin provides financial infrastructure that can scale to serve a large and diverse group of participants without requiring a centralized security model that (i) presupposes the health of the institutions supporting it, and (ii) can remain robust only until the point at which it succumbs to political capture. Nick Szabo, inventor of bit gold, a precursor to bitcoin, and a pioneer in the space, describes this benefit as an increase in social scalability, essentially the ability to scale direct human cooperation. To put the topic in the words of John Locke, one of the initial proponents of the rule of law in political theory, bitcoin provides historically strong assurances that economic activity will not be subject to “the inconstant, uncertain, unknown, arbitrary will of another man,” and it entirely redefines the meaning of being governed by “settled, standing rules, indifferent, and the same to all parties.”
Fiat’s Weakening Assurances
Unlike bitcoin, whose security guarantees are based on computer science and secured by computational power, the fiat monetary regime sits on security guarantees based on centralization of risk and losses and secured by a commitment to the rule of law. As this second security model ultimately relies on government interpretation and enforcement of the rules, it should not come as a surprise that political tension would pose a major test to the system. Using the framework applied to bitcoin, let’s look at some headlines showing how the fiat regime has fared recently.
In just one month:
Russia’s ability to participate in international finance was severely diminished, sending a clear message to governments all over the world that foreign currency reserves and money held in foreign institutions is not actually theirs, in times of political tension.
The Russian government, Russian banks, Russian citizens, Canadian protestors, donors to Canadian protestors, Ukrainian refugees, and the Afghan central bank had access to their money and property frozen or seized. Millions of individuals here unfortunately gained a first-hand understanding that money held in banks is not reliably accessible in a crisis. Canadians and concerned onlookers saw only partisan outrage to a “liberal democracy” using laws meant for terrorists on those peacefully protesting the government, implying that ownership and access of one’s savings and property could be revoked for the crime of expressing or supporting an unpopular opinion.
Ukrainian organizations, all Russian citizens, and Canadian protestors, in moments of elevated need, had payment processors restrict their ability to send and receive funds. Again a clear signal that access to the financial rails is subject to the “arbitrary will of another man.”
This piece began by stating that bitcoin’s path to global legitimacy would be paved by the increasingly large group of those who experience the fragility of the fiat monetary regime, and understand that it is specifically in those areas where bitcoin’s guarantees are strongest. Unfortunately, millions around the world were forced to experience those fragilities in just the last month.
One final point on weak commitments in the fiat monetary regime – on the value of fiat currency itself. There is maybe no clearer example of arbitrary governance than central banks in the fiat monetary regime. The supply and value of the currency used in the fiat regime is dictated by a group of economists who are unelected, unaudited, and untethered to any metrics other than the ones they define (and redefine). The currency printed is backed by faith in the government, making the commitment to its value a matter of circumstance, rather than procedure. Compare this to bitcoin, with a supply schedule that is public and known to all, that cannot be changed (literally – any change to the supply schedule could only result in a new blockchain) and is issued by code rather than the central bankers with their arbitrary opinions as to what is in the national economic interest.
Now, all of this is not to say that fiat money is inherently “bad,” certainly the world has benefited many times over from the growing availability of capital and credit over the last few decades. It is rather to point out the inherent consequences of decades of primacy of one, unchecked, system that relies on a centralized security model. That is, at every level, the system more closely resembles an organ of the government than one of the economy, wielded as a tool of political power rather than free enterprise. There are certainly those who think that the weaponization of money is not of concern to them, as it is not felt by them, or they view its targets as “deserving it” (a similar sentiment expressed around privacy). However, the crucial distinction is the strength of the guarantee that it won’t happen to you, and whether or not the ability exists in the first place. Again, to quote John Locke, “I have no reason to suppose, that he, who would take away my liberty, would not when he had me in his power, take away every thing else.”
Bitcoin as an Alternative
The potential of bitcoin shone through this tumultuous month. Haunting images of Ukrainians forming long lines at ATM’s to withdraw as much of their savings as possible (limits were set at ~$600) before fleeing the country were punctuated with stories of individuals transporting their bitcoin across borders and using it to secure emergency provisions and temporary housing. Stories of Russian citizens losing jobs with foreign firms due to tensions between governments were speckled with stories of employers turning to bitcoin to continue payment. Trading volumes of Russian and Ukrainian crypto exchanges spiked in the days following the invasion. The Ukrainian government even publicly posted a bitcoin address, and effectively crowdfunded a portion of its national defense spending from pseudonymous bitcoiners across the world (as of this writing, over 320 bitcoin has been sent, worth over $13 million).
Similarly, the Freedom Convoy in Canada turned to bitcoin when GoFundMe froze their funds, raising ~21 bitcoin, worth nearly $1 million, in a matter of days. The Canadian government ordered the bitcoin to be frozen, but the funds were nonetheless distributed to Freedom Convoy participants, highlighting the censorship resistant properties provided by bitcoin’s decentralization. Specifically, the challenges of freezing bitcoin that is self-custodied, rather than kept with a counterparty such as an exchange, and of preventing the transfer of an asset supported by geographically and jurisdictionally decentralized miners. However, the situation also underscored bitcoin’s limitations. As all data on the blockchain is public, and the fundraising address was posted publicly, Canadian regulators can easily see the over 100 addresses that the bitcoin was distributed to and can monitor those addresses going forward.
Conclusion
In conclusion, bitcoin’s security guarantees are strongest exactly where the fiat monetary regime’s are weakest. As those weaknesses are increasingly felt across the world, the assurances provided by bitcoin (open access, bearer ownership, censorship-resistant transfer) will increase the denominator of wealth that is stored in it. While bitcoin is not perfect (as detailed above), the strengthened commitment to rule of law it provides is not only beneficial to itself, but offers the promise of historically improved capability and freedom of economic interactions across the world. More on the limitations of bitcoin, as well as the promising technologies and companies aiming to strengthen and enlarge bitcoin’s promise as an open monetary network, will be the subject of future memos. Investing in the ability to better express and share individual ingenuity has historically been a good bet, and NGU is focused on the next, great frontier, bitcoin.