What is the value of Bitcoin? Objective explanation from the renowned investment fund Paradigm

Years ago, 24-year-old Matt Huang traveled from Silicon Valley to Beijing, where he met Zhang Yiming and recognized the future potential of the then small company "Toutiao," becoming an angel investor for Zhang Yiming. This investment has now made a profit of 2000 times.

This was just the beginning of Huang's journey as a legendary investor. After graduating from MIT, he founded Hotspots, which was later acquired by Twitter. He then became a partner at Sequoia Capital, leading the exploration and investment in the field of cryptocurrencies until he left Sequoia in the second half of 2018. He then co-founded the cryptocurrency investment fund Paradigm with Coinbase co-founder Fred Ehrsam.

Paradigm is one of the most active cryptocurrency investment institutions at present. In their daily work, they often face investors who are interested in Bitcoin but skeptical, particularly institutional investors from traditional investment institutions and family offices, who need explanations on the value of Bitcoin. Eventually, Huang decided to write an article explaining the value of Bitcoin in his eyes and addressing the most pressing questions from these investors.

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If you are an open-minded Bitcoin skeptic, it might be worthwhile to start with this article to gain a better understanding of the value of Bitcoin as a new form of monetary asset. Huang authorized Chain News to translate and publish the Chinese version of this article simultaneously with the English version.

By: Matt Huang, Co-founder and Managing Partner of cryptocurrency investment fund Paradigm, former partner at Sequoia Capital, and angel investor in ByteDance.

Bitcoin has evolved from a concept (2008) to an operational system (2009), to its first real-world usage (one Bitcoin priced at less than $1 in 2010), gradually developing to a Bitcoin price exceeding $8000, with a total market value exceeding $150 billion (as of May 2020).

Although empirically Bitcoin has been one of the best investment targets in the past decade, it remains controversial: Is Bitcoin a new form of currency? Or an investment bubble? Or perhaps a combination of both?

Investors have mature frameworks to assess assets like securities, credit, and real estate. However, for new forms of monetary assets like Bitcoin, there seems to be no readily available tool.

This article outlines a simple and intuitive framework for assessing the value of Bitcoin as a new form of monetary asset.

During our work, we often need to explain Bitcoin to investors and institutions who are new to it. Now, there is an unprecedented interest from investors in Bitcoin and its potential as digital gold.

Financial crises have highlighted the limitations of the existing system, emphasizing the need for a new system. This was evident during the 2008 financial crisis (during which Bitcoin was born), and now, with unprecedented monetary and fiscal stimulus measures being taken by governments worldwide, this situation may become even more pronounced.

Over the past 11 years, there has been a proliferation of works on Bitcoin. This article does not offer any novel insights but rather is a simple summary of our conversations with clients who are new to understanding Bitcoin.

Writing and currency are the two greatest inventions of the human brain—the former is the universal language of intelligence, and the latter is the universal language of self-interest.

Marie-Esprit-Léon Walras, French economist

Currency is an ancient and complex concept. Currency has taken many forms throughout history: from stone axes to shells to precious metals, and eventually to paper money. The most recent major transformation of currency can be said to have occurred in the early 1970s, when the United States abandoned the gold standard, the Bretton Woods system ended, and the modern fiat currency system officially began.

We can view the currency market as a competitive market like any other commodity. For centuries, gold has dominated the currency market, not by chance, but because gold possesses important characteristics such as scarcity and being unforgeable. Today, fiat currencies are primarily dominated by domestic monopoly powers in the market, but all currency assets still compete globally, with gold, the US dollar, and the euro being favored reserve assets.

Like written language, currency is a protocol standard with a tremendous network effect. For a currency to rise as a new currency asset, it must have a more appropriate core function of currency, able to overcome adoption barriers encountered by new currencies. We believe Bitcoin has solved these two problems very well.

One of the primary functions of currency is store of value: a mechanism for transferring purchasing power across time and space without constraint.

All successful currencies have fulfilled this function well. If a currency asset is no longer trusted as a store of value, its savings will quickly erode, as seen in hyperinflation economies like Venezuela.

Gold has been trusted as a store of value for thousands of years. Importantly, the supply of gold on Earth is very scarce. Trust in the scarcity of gold comes from people's understanding of nature: gold cannot be cheaply synthesized—even though alchemists throughout history have tried their best to do so.

Gold also possesses many other perfect asset characteristics, such as being easily recognizable (non-perishable), divisible, measurable (by weight), easily verifiable (through smelting), making gold unsurprisingly supplant previous forms of currency to become the global standard currency.

The emergence of paper money was to simplify the daily use of precious metals as a means of exchange (another core function of currency). While paper money was initially tied to precious metals, the value of most paper money today is freely floating and established by government fiat institutions.

The US dollar is currently the most important global fiat currency, having held the position of the world's main reserve currency for the majority of the last century (replacing the pound sterling). Besides being a trusted store of value, the US dollar is also a major medium of exchange and unit of account. A large portion of global trade is denominated and settled in US dollars, regardless of direct US involvement.

Trust in the US dollar depends on trust in its government (e.g., prudent management of its monetary policy). Trusting a single institution is efficient but comes with risks. Fiat currency can lose credibility and depreciate due to government operations; during crises, governments may face short-term pressures that far outweigh concerns for long-term reputation. Facing erosion of trust, countries like Venezuela have set extreme examples of currency value becoming virtually worthless.

Many investors, including central banks, hold both gold and US dollars (or assets denominated in US dollars) as they provide complementary hedging. We can view the US dollar as a centralized currency asset that can depreciate due to a single factor, and view gold as a decentralized currency asset that does not depreciate due to a single factor.

Bitcoin is a new decentralized currency asset, similar to gold. It combines the scarcity of gold and the nature of traditional currency, while also having the digital transferability of modern currency. Although Bitcoin is still relatively young, with its inherent features, it has excellent potential to grow into a future store of value.

As a currency asset, Bitcoin must be scarce, portable, fungible, divisible, durable, and widely accepted. Bitcoin scores well in most dimensions, except for widespread acceptance:

• Scarcity: Bitcoin's supply is scarce, gradually approaching a capped supply of 21 million. Achieving scarcity in digital form is a significant technological breakthrough for Bitcoin, based on decades of advances in computer science research.
• Portability: Bitcoin is highly portable, especially stronger than gold. Any amount of Bitcoin can be stored on a USB drive, or transferred digitally to any corner of the globe in minutes.
• Fungibility: Although each Bitcoin has a different history in the public ledger, any two Bitcoins are interchangeable in practice.
• Divisibility: Each Bitcoin can be divided into 100 million units called "satoshis."
• Durability: Bitcoin is durable and does not degrade over time.
• Widespread acceptance: This is Bitcoin's main weakness—despite remarkable progress over the past 10 years, Bitcoin's acceptance is not on par with gold or the US dollar. We can consider widespread acceptance in two important dimensions: the percentage of people who trust and accept Bitcoin, and the percentage of wealth that trusts and accepts Bitcoin.

Other than these classic currency attributes, Bitcoin also has the following characteristics:

• Digital form: Compared to physically cumbersome gold, storing and transferring digital currencies like Bitcoin is cheaper and easier. Bitcoin can also be verified instantly, while gold may require a slow and manual verification process.
• Programmable: Bitcoin is programmable, which has subtle but profound implications. Bitcoin scripts enable applications like custodianship or micro-payments. Over time, we may be surprised at the content that can be built on Bitcoin (similar to our amazement at the possibilities of another programmable entity—the internet).
• Decentralization and censorship resistance: The rules of the Bitcoin network (such as its monetary policy) are managed by a decentralized peer-to-peer network involving dispersed, global users, consumers, investors, businesses, developers, and miners. It is impractical for a single participant to unilaterally influence system rules (if possible). This provides Bitcoin holders with a unique confidence: Bitcoin will not depreciate due to any currency policy decision and will always be free to hold and transfer their Bitcoins. This is valuable not only for individuals and businesses but may also be valuable for governments, as their foreign currency reserves may also be compromised by capricious policies of foreign governments.
• Universality: Similar to physical bearer assets like US dollars or gold, Bitcoin is a digital bearer asset that anyone can hold and transfer. Digital dollars (requiring a bank account supporting the dollar) or digital gold exposure (requiring an account at a trading institution) are not the same.

Having the characteristics above and being a widely accepted store of value implies a significant advancement over gold. However, Bitcoin currently lacks widespread acceptance and remains in a nascent state as a store of value (compared to gold's thousands of years of history and credibility). To become a superior product is not enough; Bitcoin must have an excellent market entry strategy to be widely accepted by the public.

Since Bitcoin's inception, many savvy investors have observed it as a bubble. Their views are not wrong, but the real reasons are not fully understood by them.

If we define bubble assets as those overvalued compared to intrinsic value, we can say that all currency assets are bubble assets.

By definition, a store of value tool is an intermediary asset that people need, not because it has a direct use, but because it has the ability to become valuable in the future. This value is reflexive: if people think others will believe in its value, then they will believe in this store of value (others also expect others to believe in it, and so on).

This phenomenon is markedly different from other asset types, which have speculative demand based on utility demand. For currency assets, utility exists in collective speculation.

Nobel laureate in economics, Robert Shiller, observed: "Gold is a bubble, and has always been a bubble. It has some industrial uses, but fundamentally it's a short-term speculative bubble that's lasted thousands of years."

We can view currency as a never-ending bubble (or one that has not burst yet)—the value of fiat currencies, gold, or Bitcoin depends on shared beliefs. Other factors, including government power, industrial uses of gold, or the prosperity of the Bitcoin codebase, can enhance this belief, but belief is key.

Generating such a large amount of value from shared belief seems cyclical and non-fundamental. However, the social and economic cooperation facilitated by currency assets has real value (similar to the real value of a universal language).

Moreover, this shared belief cannot emerge around any asset—successful currency assets must compete based on inherent characteristics to win this belief. Superior inherent characteristics explain why gold is favored as a currency asset over silver or fur, and why Bitcoin is better than any number of Bitcoin imitators.

If Bitcoin successfully becomes a trusted store of value, its ultimate state is a bubble. The bubble is also the path for Bitcoin to gain wider acceptance.

There have been at least four bubbles in Bitcoin's 11-year history.

• 2011: From $12 in April 2011 to $31 in June 2011, then down to $2 in November 2011
• 2013: From $13 in January 2013 to $266 in April 2013, then down to $65 in July 2013
• 2013-2015: From $65 in July 2013 to $1,242 in November 2013, then down to $200 in January 2015
• 2017-2018: From $1,000 in April 2017 to $19,500 in December 2017, then down to $3,500 in December 2018

The characteristics of each bubble period are quite similar. When the Bitcoin market is sluggish and unattended, highly devout investors start buying coins. This triggers a rise in the price of Bitcoin, attracting media attention, which in turn attracts investors (or speculators), many of whom lack faith in Bitcoin and have shorter investment horizons. More people buying coins drive the Bitcoin price higher, attracting more attention and greater investment interest. This cycle repeats until demand is exhausted, and the bubble bursts.

Even though investors who have gone through bubble periods may have painful memories, each bubble has sparked greater external interest in Bitcoin, driving Bitcoin's expanded acceptance and gradually expanding the community of long-term holders who firmly believe Bitcoin will become the future store of value. The floor price of Bitcoin after each bubble burst has become progressively higher, demonstrating this momentum: $2 in 2011, $200 in 2015, $3,500 in 2018.

As Bitcoin becomes more widely accepted, what kind of future can it have? Some speculate whether people's salaries or daily expenses will be denominated in Bitcoin in the future. While this behavior may exist to some extent, Bitcoin seems unlikely to challenge the US dollar's role as the primary medium of exchange and unit of account (at least not in the short term). Instead, Bitcoin will have the opportunity to compete with and equal gold, becoming a very wise part of many investment portfolios.

Early adopters and tech-savvy individuals will be the first to join this group. And as time progresses, we hope their ranks will continue to grow, with more investors and institutions joining in. Ultimately, central banks may consider Bitcoin as a supplement to their existing gold reserves.

Lastly, the boom and bust cycles of currency assets last longer than human lifetimes, making them difficult to predict. Before the US dollar became the global primary reserve currency, this position was held by currencies from the UK, France, the Netherlands, and even ancient Greece and Rome. Similarly, there was a time before adopting gold when more primitive forms of currency dominated. The idea of decoupling fiat currencies (like the US dollar) from gold itself is a recent phenomenon, unimaginable half a century ago. It seems likely that the global currency order may change in ways we cannot imagine today, and digital currencies like Bitcoin will play an important role.

As a decentralized store of value, Bitcoin's market value is naturally considered in reference to the gold market size. The total value of gold is estimated at around $9 trillion (as of May 2020), divided into central bank reserves (17%), private investment holdings (22%), jewelry (47%), and other various forms (14%). Bitcoin can cover a portion of this value, but not all.

Over time, demand for assets like gold and Bitcoin may expand beyond $9 trillion, especially considering the predominant direction of loose global monetary policies. According to data from the International Monetary Fund (IMF), total international reserves reached approximately $13 trillion in 2019, consisting of gold (11%), foreign exchange reserves (86%), and assets related to the IMF (3%). If governments outside the US (some of which are already jittery about their reliance on US dollar forex reserves) begin adopting Bitcoin as a supplement to their existing gold reserves, the market size of Bitcoin could dramatically expand.

In addition to potentially supplementing the investment demand for gold, Bitcoin can indirectly cover