Know What You Hold - Gold, Bitcoin, Altcoins and Government Reserve Funds

I recently posted a comment on X that I thought was rather self evident:


However, it generated a lot of responses which indicated otherwise. The responses to the post got to be a bit much to respond to individually and X really isn't a good medium for long form discussion with many participants, so I'm attempting to provide more clarity on my comment here.

Lummis/Saylor advocating sell gold to buy Bitcoin​

Back in July, Senator Cynthia Lummis introduced the Boosting Innovation, Technology and Competitiveness through Optimized Investment Nationwide (BITCOIN) Act in the U.S. Senate. It is a bill that calls for selling the US Treasury's gold reserves and using the resulting funds to acquire Bitcoin instead.

Michael Saylor recently threw his support to the idea on social media which has fostered increased interest in the idea amongst so called "Bitcoin Maxis" (Bitcoin evangelists whose support for Bitcoin borders on religious zeal).

While establishing a strategic reserve of Bitcoin is reasonable given El Salvador's experience and the potential for allocated funds to appreciate faster than inflation, selling the nation's gold reserves to do so is a terrible idea. To understand why, we need to "know what we hold".

Gold vs Bitcoin​

Many pundits (and even Federal Reserve Chairman Jerome Powell recently) has described Bitcoin as "digital gold" - equating Bitcoin to a digital store of value asset with the same characteristics as gold. But this is not correct. Bitcoin entails many risks while gold does not.

I have touched on this topic previously, but mostly from the narrow point of view considering only its use case as a transactional currency. This is an important issue, so let's explore it in more depth here.

Bitcoin Immutable?​

Gold is durable - it cannot be transmuted or changed into anything else. It is truly immutable.

Bitcoin Maxis tout Bitcoin as immutable - that it can not and will not change (structurally/technically). This is not 100% true as evidenced from the drama surrounding the arguments on Bitcoin's development circa 2017 which ultimately culminated in the creation of Bitcoin Cash as a hard fork of the Bitcoin network.

In fact, the Bitcoin Protocol undergoes changes periodically:

... ordinal NFTs as they exist today were made possible by the Segregated Witness (SegWit) and Taproot updates to the Bitcoin Protocol, which took place in 2017 and 2021, respectively. ...

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All it takes is consensus amongst the node operators. This is where decentralization of the network operators becomes important - making such changes infrequent and difficult to achieve.

Economics of Bitcoin Mining is Effecting Centralization​

Decentralization is an ideal. It's not a well defined threshold that can easily be quantified, verified and proven. When we discuss decentralization, we generally mean achieving sufficient decentralization to mitigate/avoid security problems and centralized authority/control.

When Bitcoin was released into the world, the network grew as individuals, hobbyists, enthusiasts and the curious set up home computers to run Bitcoin mining software. The hardware requirements for running a mining rig (that would successfully mine BTC) were low - there wasn't any barrier to entry and everyone could participate if they wanted to. This environment fostered an excellent level of decentralization.

14 or so years later, this is no longer the case. Bitcoin mining is seriously competitive and to recoup hardware and energy costs, you need to have state of the art infrastructure. Bitcoin mining is now the purvue of dedicated companies setting up data centers with hundred or thousands of mining computers. This is leading to a degredation in the decentralization of the Bitcoin network. Some have argued that the BTC network is already too centralized:

... Bitcoin’s centralization is a problem that concerns the entire market, especially now when only two mining pools produce the majority of its blocks.

CryptoSlate looked at Bitcoin’s global hash rate distribution and found that more than half of it came from Foundry USA and Antpool.
...

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...
Today, five mining pools control over 85% of the total bitcoin mining power. Who are they? Why did this happen? And what are the risks of the concentration of bitcoin mining power?

The landscape of the bitcoin mining industry is different from where it was just two years ago. Having undergone major geopolitical changes and mining pool liquidity crises, the bitcoin mining sector has changed.

It is no longer about independent miners. Now it is centralized mining pools, which play the most significant role in the bitcoin mining industry.
...

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Those citations are over a year old. I included them to illustrate the point that Bitcoin's claim on decentralization - something Bitcoin Maxis will proclaim loudly and often - is not as bedrock today as it was over a decade ago.

Bitcoin is not a Practical Global Payment Rail​

The arguments that led to the creation of Bitcoin Cash back in 2017 effectively locked Bitcoin into a model that capped its maximum transaction throughput. Bitcoin has a maximum transaction capacity of somewhere around 7 and 13 transactions per second. This is nowhere near enough to work as a global payment rail.

For perspective (and mostly just considering transactions in the USA):

...
In 2023, nationwide credit card transactions totaled 53.8 billion for an average of 147.5 million per day, 6.15 million per hour, 102,450 per minute. or 1,708 per second.
...

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From the 2023 Network Volume .PDF document in the 2023 ACH Network Volume Statistics archive link:

The ACH Network averaged more than 126 million payments per day.

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126 million / 86,400 seconds per day = 1,458.33 transactions per second.

To really function as a practical global payment rail, a blockchain is going to need transaction throughput in the five or six figures per second range at minimum. This is several orders of magnitude beyond Bitcoin's maximum ability and not something that can be solved with a simple tweak of the network.

Layer 2 Solutions like Lightening Network are Not the Solution​

Layer 2 solutions like the Lightening Network essentially abstract transactions away from the Bitcoin network:

...
Bitcoin was envisioned and created as a peer-to-peer electronic cash system. This meant that users could transfer value without an intermediary. At the time of its inception, the creator(s) of Bitcoin concentrated on these two aspects mainly, without focusing on scalability and transaction throughputs.

While at the initial stages, this wasn’t too much of a hassle, as years unfolded, this proved to be a conundrum. It was commonly known to be the blockchain trilemma where blockchain architects had to find the right balance across decentralization, scalability and security.

Bitcoin has grown into the most decentralized blockchain and is considered quite secure. However, scalability has been a concern for Bitcoin-based transactions. Transactions take anywhere between two minutes to several hours to complete on the Bitcoin network.

This issue has been more pronounced as new blockchains, such as Ethereum and Solana, with better transaction throughput have emerged. Ethereum’s transactions per second (TPS) of 30 is higher than that of Bitcoin’s five per second. Solana takes the comparison to new levels with up to 65,000 TPS.

The rise of scalable blockchains has left chains like Bitcoin and Ethereum with no other choice but to rely on layer-2 solutions. Better transaction throughputs are also fundamental for chains that aspire to have a healthy application ecosystem. ...
...
... the Lightning Network leverages the concept of payment channels as stated by the legendary Satoshi Nakamoto. The protocol enables the creation of a peer-to-peer payment channel between two parties.

Once established, the channel allows the transacting parties to send an unlimited amount of transactions that are nearly instant and inexpensive. It acts as its own little ledger for users to pay for even smaller goods and services, such as coffee, without affecting the Bitcoin network.

To create a payment channel, the payer must lock a certain amount of Bitcoin onto the network. Once the Bitcoin is locked in, the recipient can invoice amounts of it as they see fit. If the customer wants to keep the channel open, they can choose to add Bitcoin consistently.

By using a Lightning Network channel, both parties can transact with each other. When contrasted to ordinary transactions on the Bitcoin blockchain, some transactions are handled differently. For instance, when two parties open and close a channel, they are only updated on the main blockchain.

The two parties can transfer funds to each other indefinitely without informing the main blockchain. As all transactions on the layer-2 protocol do not need to be approved by all nodes, it substantially speeds up transactions. ...

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They are essentially trading (limited) scalability for security. Using them entails trusting a third, party with centralized control. This stop-gap solution will never be superior to a competitor that maintains a decentralized model while solving the scalability issue.

A Peer to Peer Payment Rail was the Promise that Generated Interest in Bitcoin​

In the orignal Satoshi whitepaper on Bitcoin, he says:

Bitcoin: A Peer-to-Peer Electronic Cash System

Abstract
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. ...

1. Introduction
...
What is needed is an electronic payment system based on cryptographic proof ...
...
12. Conclusion
We have proposed a system for electronic transactions without relying on trust. ...

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The whole point of Bitcoin was to function as a peer to peer payment rail. While the design of the Bitcoin network succeeded in achieving its goals for establishing a functional transaction network, it failed in achieving a sufficient transaction throughput (scalability) to make it practical for global (or even just widespread, heavy) use.

Bitcoin's Deflationary Tokenomics Work Against Payment Rail Adoption​

One of Bitcoin's most well known features is its capped tokenomics (supply). There will only ever be 21 billion Bitcoin with the generation of these coins produced at a rate that cuts in half every four years. The deflationary tokenomics is a big driver in the FOMO argument that drives a lot of Bitcoin investment.

While this deflationary feature is supporting Bitcoin's claim as a store of value asset, it is also a headwind for adoption of Bitcoin as a currency (a practical transaction medium). Gresham's Law works against Bitcoin in this environment where inflationary currencies can be used instead.

Bitcoin's Store of Value is largely due to network effect​

As it is obvious that Bitcoin is not practical for use as a global payment network (for reasons discussed above), that leaves its utility as essentially a store of value. And while its dollar price has been historically very volatile and not the model of what anyone might rightly consider a store of value, Bitcoin's first mover advantage has established a significant network effect for valuation amongst cryptocurrencies. Institutional adoption and State interest seem likely to maintain a floor for Bitcoin's store of value proposition. But investment and interest can be fickle - this support is not guaranteed.

Bitcoin's Security Model Could Become at Risk​

For the last decade plus, the economy for Bitcoin miners has been driven by the reward for mining new Bitcoins. Bitcoin miners have significant overhead (mining hardware, real estate to operate) and operating costs (power/energy). The rate of new Bitcoin generation is slowing down however every four years in programmed sequence commonly known as the halving.

As new Bitcoin generation dwindles, miners reward for maintaining network nodes primarly stem from block rewards paid via transaction/gas fees. This is a problem for a network that has a very low maximum transaction throughput. As the cost of energy increases, the profitability of mining Bitcoin (or running a network node to maintain the network) decreases. This needs to be offset by a corresponding rise in the market price for Bitcoin or mining could become unprofitable.

While this has not happened yet, it remains an existential risk for Bitcoin.

Competition for Alternative Payment Rail Accelerating​

Bitcoin sparked a lot of entreprenurial interest in the idea of cryptocurrencies and that has led to the development of numerous alternative blockchain technologies with alternative consensus models. See here for a deep dive on the subject.

For our purposes, it suffices to say that innovation did not stop circa 2017 when Ethereum was seen as a realistic challenger to overtake Bitcoin for crypto dominance. Ethereum has its own limitations/issues and this has left the door open for smart people to continue innovating in the hopes of building a better mousetrap. This is giving rise to newer systems that are pushing the boundaries on scalabiltiy (transaction throughput), cost (energy efficiency) and accessibilty (hardware requirements to run a node) while maintaining security (decentralization). In addition, many blockchain systems are moving to fully decentralized governance models as the blockchain technology has matured and proven itself.

There is currently a lot of competition in the "alt-coin" space for developers to build upon these chains and create value. There are a lot of interesting projects happening in the space with DePINs, Real World Asset (RWA) tokenization, DeFi and zero knowledge proof (zkP) systems.

I expect that eventually the market is going to coalesce on one chain with the best technology, economics and/or marketing. When that happens, the winner is likely to challenge Bitcoin for market dominance in the crypto space. When that happens, Bitcoin's network effect advantage will suffer. Bitcoin is not ready for this - even if it is many years out on the horizon.

Tether Market Manipulation is a Possibility​

In Bitcoin's recent run to USD$100K, concerns about Tether's role in propping up the price of Bitcoin have once again been renewed:

Tether minted an additional $2 billion in USDT in the late hours of December 6, concluding a month-long minting spree that has added $19 billion in liquidity to the crypto market. This has stirred up a growing concern from the crypto market, which is questioning the company’s transparency.
...
The crypto community has raised questions about the adequacy of Tether’s reserves amid its rapid minting activity. Critics warn that issuing large volumes of USDT without transparent proof of backing could erode trust and shake market confidence, especially if the company fails to provide sufficient evidence of its reserve holdings.
...

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Some people claim concerns regarding Tether are just FUD. However, until Tether provides more sunshine on their treasury via a comprehensive, independent, third party audit, it will remain an open question.

Should any defect (ie. fraud) in Tether's operations be discovered one day, it is likely to have a domino effect on the entire crypto market much like what occurred in the wake of the FTX scandal.

Bitcoin's Value is Subject to Numerous Risks, the Future is Unknown​

Bitcoin will likely ride its network effect advantage for a number of years and appreciate in price nicely. I own a bit of Bitcoin and have owned it for many years now. I expect to hold it for many years to come.

But I am also aware that Bitcoin is subject to numerous risks of varying quality. It is important to understand these risks when evaluating an asset's suitability for, and potential allocation to, a portfolio.

Gold is the ultimate zero counterparty risk reserve asset. It is a store of value insurance that anchors a portfolio against all risks including fiat currency crisis, geo-political turbulance, and even cryptocurrency volatility. Central banks still understand tradition even if the public does not.

I am not opposed to the USA creating a "Strategic Bitcoin Reserve". I actually think it would be a good idea. I am, however, strongly opposed to selling gold in order to fund it. That's crazy.