Think Bitcoin™ Issue #5
Assessing risks; legal tender in El Salvador; Bitcoin as global reserve asset; the difficulty adjustment
Happy Labor Day weekend, friends. And welcome back to Think Bitcoin™. As always, if you’re brand new or relatively new to Bitcoin and looking for some education on the basics, feel free to scroll down to the “For the new and new-ish” section and work your way up.
In this issue:
Content Round-up: 3 articles, 2 podcasts
Headlines/News: Treasury Department still up to their old tricks, Twitter adding BTC payments, Gensler still side-eying DeFi, Uniswap under investigation, El Salvador closes in on legal tender; Bloomberg says Bitcoin on its way to reserve asset status
For the new and new-ish: Overview of the “difficulty adjustment”
As always, if you find this newsletter interesting or useful, please share it with others who might find it interesting or useful!
Content Round-Up
1. “Bitcoin Risk Assessment,” an episode of the What Bitcoin Did podcast, featuring Lyn Alden. In this episode, host Peter McCormack and Lyn Alden assess potential risks to Bitcoin’s continued success. As Alden says at the outset, “If you’re on the titanic and you think you’re unsinkable, you’re more likely to hit an iceberg, whereas if you’re on the titanic you still want to be looking out for icebergs.” Throughout the episode they look for and discuss potential icebergs.
This is a great episode for a couple of reasons. First, McCormack is really good at asking fundamental questions and soliciting explanations from his guests that are more easily digestible for folks new to Bitcoin. He will stop his guests and ask them to explain concepts they talk about, which I think is really useful. Second, it’s healthy and important to constantly be looking out for risks and to be doing so in an honest, even-handed way.
McCormack and Alden discuss:
whether governments can or will ban it
potential bugs in the code
quantum computing
potential for a major exchange hack
the transition from block subsidies to exclusively transaction fees for miners
declining bitcoin dominance / potential for alt-coin rivals
2. “Why Insurance Companies Need Bitcoin,” an article by Mike Hobart. In this piece, Hobart discusses the rapidly rising price of insurance premiums over the last 30 years and why adding some bitcoin to the balance sheet may help insurance companies meet obligations without being forced to continue hiking premiums.
The rationale is that insurance companies invest significant amounts of the money they hold into U.S. Treasuries, which are putatively safe investments. However, with Treasury yields declining significantly over the last few decades (they’re currently negative-yielding in real terms), these investments are not growing (let alone preserving) insurance companies’ pools of money. Couple this with the alarming state of health in America, and we have a recipe for higher and higher premiums. Bitcoin preserves and increases purchasing power in an environment of accelerating fiat debasement. Thus, Hobart argues, insurance companies should strongly consider adding some to their respective balance sheets.
3. “Government Centralization vs. Bitcoin Decentralization with Greg Foss & Aaron Segal,” an episode of the Fed Watch podcast. In this episode, the participants begin by discussing centralization vs. decentralization as enduring societal forces, almost always working against each other. They discuss the downsides to centralization, particularly as it relates to geopolitics and global peace. There’s a lot of talk about China, what China may be up to with some of its recent economic moves, and tensions with Taiwan.
Aaron Segal makes a claim that will initially sound utterly heretical to personal finance and FI/RE folks. He boldly asserts that “passive investing is communism.” Why? Because it is a massively centralizing force that favors/rewards the size of companies as opposed to quality or potential. The idea is that passive investing (by which he means price-insensitive, low-cost index-fund investing) drives all the money into enormous companies that make up huge percentages of these indexes. Size is rewarded with more capital, which creates more size, which draws more capital, and so on and so forth. Money is not allocated to companies based on quality or potential. It’s instead price-insensitively plowed into market indexes as a whole. Segal argues that this “socializes the financial markets at the cost of new investment,” which creates fragility. Fragility invites centralized interventions, which continue to divorce the capital markets from underlying value, leading to more centralization, etc.
Segal believes this is a one-direction path and predicts (correctly, in my opinion) that the Fed will never really be able to stop quantitative easing. The TLDR of this line of thinking, which is much more prevalent than I think FI/RE folks realize, is that passive index-fund investing is poor capital allocation that distorts price signals and creates a lot of market misinformation. In Segal’s view, Bitcoin, as the most decentralized and decentralizing asset, is the only life raft.
4. “As Your Other Assets Inflate, Bitcoin Can Protect Your Savings,” an article by Dylan LeClair. LeClair explores the macroeconomic corner into which the United States has painted itself. He discusses how a nation with ballooning twin deficits (“twin” meaning a both a balance of trade deficit and a fiscal deficit) is seemingly faced with two options, neither of which is optimal.
Option #1 is defending the integrity of the dollar by halting quantitative easing and raising interest rates. However, this would crush asset prices and wreck the debt-filled global economy, which would also have downstream social effects, as unemployment would increase, asset values would decrease, and people would be pissed.
Option #2 is keep pumping the markets with QE and money printing, thereby devaluing the dollar further. This would keep asset prices nominally high, making folks happy (at least in the short-term), because they’ll think they’re getting rich. Meanwhile, the unit of account (the dollar) is debased at an accelerating pace until eventually trust erodes and we have larger problems on our hands.
Bitcoin, LeClair argues, is the insurance policy for these outcomes.
5. “Five Limiting Beliefs That Prevent You From Buying Bitcoin,” an article by Sylvain Saurel. This is a quick read, but I think it’s useful. Saurel discusses a “fixed mindset” approach to Bitcoin versus a “growth mindset” approach. Those with the latter are more likely to embrace the opportunities Bitcoin presents. To help jolt folks out of a fixed mindset, he runs through five very common beliefs about Bitcoin that limit and inhibit folks from stepping into the space.
Headlines/News
Biden administration pushing Democrats to add more crypto tax requirements in the $3.5 trillion budget reconciliation package
Last week the Treasury Department sought to assure the crypto community that, despite the infrastructure bill’s expansion of the definition of “broker” to include many non-brokers in the crypto space, they wouldn’t actually go after any non-brokers. Essentially, they were asking the crypto community to take them at their word, an exceedingly difficult prospect these days, given the behind-the-scenes lobbying from the Treasury Department during the Senate debate over the infrastructure bill and their open distaste for cryptocurrencies. Crypto advocates did not appreciate the last-minute provision that was added to the bill, which set off weeks of intense debate, public outcry, and tireless lobbying efforts.
This week, the Treasury Department is reportedly pushing Democrats to include additional crypto tax requirements in the $3.5 trillion, filibuster-proof budget reconciliation package. Reportedly, the Treasury Department wants to collect more information from exchanges (and businesses) relating to foreign account holders for the purposes of trading this information with other countries in exchange for information relating to U.S. crypto holders abroad. The administration wants to make sure no American crypto holder anywhere on earth is getting away with avoiding American taxes.
As Jerry Brito of Coin Center tweeted, the space is certainly not opposed to reporting requirements. Quite the contrary. But these requirements should not be slammed into must-pass bills at the last minute with no input from the public. Unfortunately, this type of maneuvering has become the modus operandi of the Treasury Department.
Gary Gensler speaks in front of European Parliament’s Committee on Economic and Monetary Affairs
On Wednesday, SEC Chair Gary Gensler spoke, yet again, about his desire to bring crypto within defined regulatory parameters and reiterated his skepticism about most non-bitcoin tokens. In response to the idea that some crypto tokens may be “utilities,” Gensler said, “These tokens are not like a laundromat token. They are highly speculative investment tokens for people who are trying to save or speculate for their future, and that's why it is appropriate to bring them inside the investor protection perimeter.”
Gensler noted the SEC is particularly focused on exchanges, both centralized and decentralized. He seems particularly focused on corralling the latter into a more clearly defined regulatory framework. Speaking of which…
Uniswap is reportedly being investigated by the SEC
Uniswap, a popular decentralized exchange, is reportedly being investigated by the SEC, who appear to be focused on the governance and marketing of the platform. I am not an expert on DeFi, but it’s important and relevant to note that Uniswap, like many non-bitcoin projects, is one that took on initial investors who received tokens. This, coupled with the governance structure it appears to maintain, seems to be setting off alarms in the minds of Gensler and others who are obviously looking at these traits as legally indicative of security-status per the Howey Test.
Bitcoin to become legal tender in El Salvador
On September 7, Bitcoin will officially become legal tender in El Salvador, pursuant to the “Bitcoin Law,” which passed the Salvadoran Congress by a supermajority on June 9 of this year. Pursuant to this law, businesses must accept bitcoin as payment for goods and services.
El Salvador’s Legislative Assembly has created a $150 million Bitcoin trust for the purposes of allowing businesses to immediately convert bitcoin to U.S. dollars, if so desired. The Assembly has also set aside millions of dollars to install government-backed Bitcoin ATMs. The government has created the Chivo wallet, through which every adopter will be air-dropped $30 of bitcoin on September 7. The use of this particular government-supported wallet is optional, though.
Many in the Bitcoin community are understandably excited about El Salvador’s landmark adoption of bitcoin as legal tender. It is certainly an opportunity for uplift, for protection against continued debasement of the dollar (El Salvador is a dollarized country), and for attracting business. However, there are certainly some Salvadorans who appear to be skeptical of the move. There have been small protests this week, and one vocal critic was arrested without a warrant and briefly jailed, allegedly for “financial fraud.” He was later released but, needless to say, the optics of the arrest were not good. No one in the Bitcoin community supports forcing adoption on anyone, and this incident was met with significant criticism from Bitcoiners. It does seem as though the protests are a bit more about President Bukele than about Bitcoin, specifically.
It’s also worth asking whether it’s too early for this type of use case, an argument I’ve heard a few people make. Bitcoin is still a swiftly appreciating asset. As the hardest, best form of money in a debt-obsessed, fiat world, value continues to accrue to it. This will only continue as fewer and fewer new bitcoins are minted with each subsequent halving. Eventually, in a “hyperbitcoin-ized” world, bitcoin’s price will be less parabolic and more stable, but the price at which this begins will be much, much higher than what it currently is. This obviously begs the question of whether its optimal use case now is as a medium of exchange or a store of value, understanding that it will of course eventually be both. And what are the risks, if any, to global adoption if the experiment in El Salvador does not go as well as hoped?
I think these are fair questions. One obvious rejoinder is that optimal use cases are situational. We in the the U.S., particularly those of us who are investors, tend to view use cases through the lens of long-term value appreciation, which is a markedly privileged position to be in. We rarely consider things like remittance payments, which constitute almost 25% of El Salvador’s GDP, per the World Bank. Remittances involve exploitative middlemen who take massive cuts of payments. Bitcoin absolutely, unquestionably fixes this, keeping more money in the hands of the people.
There’s certainly more to explore here, and we will most definitely be following the roll-out to see how it goes. It is undoubtedly a huge moment in the history of Bitcoin, and I’m excited about it.
Twitter testing Bitcoin option for Tip Jar feature
Twitter is reportedly testing a bitcoin payment option for their tip jar feature, which allows users to support accounts they follow with tips, in addition to likes and retweets. The bitcoin option would use the Lightning Network and be compatible with Square’s forthcoming hardware wallet.
It seems like Jack Dorsey is making Bitcoin moves on an almost weekly basis these days. He’s been one of Bitcoin’s most vocal and sincere proponents for a while now, and he’s made it clear his focus is on making it accessible for as many folks as possible. At the Bitcoin 2021 Conference in Miami earlier this summer, Dorsey said “Bitcoin changes absolutely everything…I don’t think there is anything more important in my lifetime to work on.”
He added: “if I were not at Square or Twitter, I would be working on bitcoin. If [bitcoin] needed more help than Square or Twitter, I would leave them for bitcoin. But, I believe both companies have a role to play.”
Bloomberg publishes September crypto report - sees Bitcoin as potential reserve asset
Bloomberg published the September 2021 edition of its Crypto Outlook report, which contained some remarkably bullish predictions. The authors see Bitcoin heading to $100,000 as the “path of least resistance.” More notably, however, the report asserts that Bitcoin is “well on its way to becoming the digital reserve asset in a world going that way.”
For the new and new-ish
Last week we discussed validating blocks, how new bitcoins get minted, and Bitcoin’s halving cycles. As always, if you missed that one, I encourage you to revisit it before forging ahead on this week’s topic, which is something called the “difficulty adjustment.”
So we know that miners use computer power and electricity to run announced transactions through a hash function (the sha256 hash function) to try to get an output that falls within a pre-determined range. Being the first to do so means the miner is rewarded with new bitcoins and transaction fees, provided the transactions are verified by the nodes on the network. We know that nodes are computers running the Bitcoin software. We also know that once a proposed block of transactions is validated it is appended to the blockchain as the newest block.
I want to clarify a detail about the information that miners are running through the hash function, which relates to the security and integrity of the blockchain itself and also explains how each block connects.
We know that miners are taking the bundle of announced transactions and running it through the sha256 hash function to try to get an output within the pre-determined range. Recall our example last week of the suitcase going through the airport security machine. In addition to announced transactions, though, miners add two other pieces of information that get bundled with these announced transactions as the input that goes through the hash function and creates an output.
These two additional pieces of information are the “winning” output number from the previous block and something called a “nonce.” The winning output number from the previous block (called the “hash” of the previous block) is how the blocks in the chain connect to each other. The hash of the previous block is a part of the input for any new block.
Why is this important? If you change a single character of an input into the sha256 hash function you will get a different output. This means you can’t tamper with previous blocks in the ledger without recomputing every subsequent block. This helps make the blockchain secure, but it also makes transactions final. There are no chargebacks, no 90-day settlement periods, etc. on the blockchain.
A “nonce” is just a random number that differentiates the inputs each miner is hashing, so as to distinguish the winning miner.
So far so good. Now, switching gears a bit, remember the halving cycle we talked about last time? It’s the schedule by which the amount of bitcoins rewarded to winning miners is cut in half every four years. This is a strict schedule. We know exactly how many blocks there are to go before the next halving (you can follow this yourself here). In order for this schedule to be accurate, we need to have a pretty fixed amount of time allotted for each new block to be mined and added to the chain. If things move too fast, the halving schedule gets disrupted. Ditto if they move too slowly. The perfect amount of time per block is approximately 10 minutes.
Imagine your incentives, though, if you’re a miner. You know you get rewarded with new bitcoins each time you’re the one to mine a new block. You want as much bitcoin as you can get. So you acquire more and more computer equipment so that you can run more and more inputs through the sha256 hash function, giving yourself a higher chance to find an output within the pre-determined range (this is called increasing “hash rate”). This also speeds up the time it takes to find a winning output. The more computer power at work means finding the winning output in a shorter amount of time.
Well, this obviously appears to screw up the 10-minutes-per-block dynamic essential for maintaining the halving cycle. It also seems to allow for larger operations to come in with a larger hash rate and win more bitcoin rewards.
On the other side of the coin (pun semi-accidental), if there’s less computer power at work in the network (meaning there’s less total “hash power”), it may take longer than 10 minutes to find a winning output, which is also problematic.
Bitcoin solves these potential problems with something called the “difficulty adjustment. Every 2,016 blocks (about every two weeks) the Bitcoin algorithm (the sha256 operation) adjusts the “pre-determined range” we keep talking about to be either smaller (more difficult) or larger (less difficult), depending on the network hash power at the time. This way, the 10-minute block intervals are kept at roughly 10 minutes.
For example, when China essentially kicked bitcoin miners out of the country earlier in the summer, the subsequent difficulty adjustment lowered the difficulty because there was less hash power (temporarily) on the network. As hash power ramped back up, with many miners moving to the U.S., the difficulty was adjusted upward again. And the blocks have kept being produced, without fail, throughout.
Bonus/Miscellaneous
Over the last few weeks, we’ve discussed extensively the infrastructure bill in Congress and the last-minute anti-crypto provision it contained. The effort undertaken to amend the language and the debate that ensued was, I think, notable both for the strange political bedfellows it made and for the recognition of a growing crypto constituency. I plan on writing much more on this topic in coming weeks, but I saw this graphic below on Dan Held’s LinkedIn this week, which I thought was interesting and on-point. I think it’s very much worth exploring how we might break out of our stale, limiting, ultimately counterproductive political paradigms, and the role Bitcoin could play in expanding/liberating our political imaginations and political machinery.
As always, thanks for reading! If you enjoyed it or found it useful, share this newsletter widely and freely!
“Civilization is in a race between education and catastrophe. Let us learn the truth and spread it as far and wide as our circumstances allow. For the truth is the greatest weapon we have.” -H.G. Wells
Hope you’re all having great long weekend.
See you next week,
Logan
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DISCLAIMER: I am not investment advisor and this is not investment advice. This is not, nor is it intended to be, a recommendation to buy or sell any security or digital asset. This newsletter exists for educational and informational purposes. Do your own research before making any investment decisions.
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