Blockchain Briefs: The True Value of Crypto-Coins

By @Юрий Шишацкий (Iurii Shyshatskyi)

This post will focus on the blockchain security, coin supply, and inflation. We will also explore if cryptocurrency can be compared with or replace real-world goods such as gold or precious metals.

When people think about crypto-coins they imagine something solid and made of metal. Bitcoins and altcoins usually appear on images in headlines as coins made of gold or some other type of precious metals. These fancy images affect our perception and psychology. Therefore, it is hard to think that the qualities of these digital records called ‘coins’ deteriorate with time. Yet another misleading advertisement is the limited supply of coins. Pundits and crypto enthusiasts typically refer to it as something good. Moreover, most people’s personal experience in regards to value and money will usually have them accept this statement. It is really hard to admit that this monetary policy leads to destruction.

From ancient times precious metals served as a form of currency because of their qualities. Not only were precious metals scarce, but they are also known for their resistance to corrosion and oxidation. Coins and jewelry made of these precious metals were made to last hundreds of years unless somebody intentionally mistreats them. Within recent times, some observers claim that Bitcoin or some other crypto-currency can be treated as a value storing commodity, like gold. Their first argument is that, like gold, some cryptocurrencies are scarce since some of them will have a limited supply. The second argument is the fact that coins are digital records and the blockchain is an extremely safe place to store them, therefore it has a good value storage property. The goal of this post is to show that these claims are false and the value of cryptocurrency degrades as time goes.

As we discussed in the previous part, the security of blockchain networks based on PoW relies on mining. Mining is paid by the issuance of new coins and transaction fees. Often coin issuance constitutes 99% of this payment, such as in the case of Bitcoin. Without this emission, a miner’s reward would be far less than it is now and even the biggest blockchains would be under threat of 51% attacks. One may think that transaction fees could be increased and one day replace coin emission as it was suggested by Bitcoin creator Satoshi Nakamoto. This is not likely to happen because people are not interested in paying high transaction fees. Bitcoin and similar blockchains provide convenience and low transaction fees, which are their main advantages. Users always to tend to pay the lowest transaction fees to place their transaction record into the chain. Moreover, if fees in one blockchain network will be less than in another, we can expect that people will migrate from the first to the second one. Therefore, we can say that the coin issuance is the main mechanism that protects the blockchain.

Before we continue, we must first learn about a few concepts. The first of them is the security budget. This is the cost of all coins issued in the network within one year. The time interval of one year is taken because it is the typical lifetime of a mining hardware unit. Often miners invest in hardware, it will work for around one year, then they substitute it with new purchases of more efficient hardware or close down their business. The security budget is the amount of money needed which should cover their investment and electricity bills for one year. On the other hand, this number shows the magnitude of money which an attacker can invest to perform a successful attack or even take control of the network. In the case of Bitcoin, the security budget is approximately $460 million per year (at the time of writing) given that block reward is 12.5 BTC and one BTC is worth $7,000. Similarly, the security budget of Bitcoin Cash, the fifth-largest blockchain network by market cap, is around $13 million. Many cryptocurrencies listed in https://coinmarketcap.com have a market cap which is 10 times less than the Bitcoin security budget.

The second important concept is the security factor. This is the fraction of the security budget divided by the market cap of cryptocurrency. It describes what portion of market value will malicious actors have to invest to gain control of the network. So if there is a blockchain network with a low-security budget but high capitalization and volume of everyday transactions, it may be very attractive to malicious actors. The security factor characterizes this ratio. There is another formula for the security factor, it is the number of issued coins within the year divided by total coin supply on the market. We simply divide the nominator and denominator by the price of one coin. The second fraction is something that is known as monetary inflation. Here, we can see there is a deep connection between monetary inflation and the security of the network.

There are two types of inflation: monetary inflation and price inflation. Price inflation is an increase in the price of goods and services. It could be caused by different reasons, one of them is an emission of new banknotes or monetary inflation. Monetary inflation doesn’t always cause price inflation. For example, Bitcoin and many altcoins have predefined monetary inflation. At this moment most of them have 4% inflation. However, not all of them suffer from price inflation, sometimes we can even observe a price deflation. The reason is the expansion of the market which could grow much faster than 4% per year, resulting in deflation.

Most of the biggest cryptocurrencies by market cap have a halving mechanism which ensures that they will have a finite supply. People always think that this is something positive and certain coins won’t have hyperinflation in the future and their assets won’t turn to ash. Seldom think that this monetary policy leads to huge security problems is the future. Whenever a halving happens the security factor of the cryptocurrency halves two times too.

The growth of the price of the coin may somewhat reduce the impact of the halving. Nevertheless, this growth could not go on forever. What is more important is the fact that Bitcoin-like networks have properties that degenerate over time. This fact is striking: the network which was four years ago is not the same as it is now. Let’s think further — if the network degrades is it fair to think that tokens within it are as valuable as they were four years ago? This problem raises the question again, what is an intrinsic value of cryptocurrency? Some people say there is no intrinsic value. Others will say that some coin’s value is supported by the hash power spent on its creation. The author of this post believes crypto-coins (mined on a PoW algorithm) are supported by the hash rate which will be contributed by miners in the future. So it doesn’t matter how much electricity and hardware was burned in the past, these resources have already been spent. What matters is who will pay for future mining.

In the case of coins with a finite supply, one thing we can say for sure is: miners will be paid with coins that will be generated in the future. We do not know for sure how much money those coins will be money. However, we can make some estimates. Right now around 3/4 of Bitcoins have already been mined. One-quarter of the supply is still left minted to support the security of old coins. This means that the existing coins are supported by 1/3 of the coin. However, four years later 7/8 of Bitcoins will be in circulation and each coin will be supported only by 1/7 BTC. This dynamic predicts a bleak future for Bitcoin because now we can see that the minted coin’s value will diminish over time. We will discuss its longterm implications in our next Blockchain Briefs post.

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