Buying Bitcoin: A Bet on the Power Law
Crypto is a Bitcoin Story
Bitcoin? Yes, Bitcoin.
Earlier I wrote about Investing in Mavericks. I view this investing approach as mimicking "Venture Capital" investing, but in the Public Markets. This is a high-risk, high-reward investment strategy.
The first Maverick I wrote about was The Trade Desk (TTD). As of this writing, the first two purchases of TTD are up 65% and 23% respectively, handily beating the market by ~49% and ~17% respectively. You can follow TTD’s performance, along with those of other Mavericks, on the Scorecard here.
In that first article, I said that if you answer Yes to all of the below checklist questions, then TTD may be a Maverick worth consideration.
Is the company a Leader in a Large Growing Market?
Does the company have a Growing Competitive Advantage?
Does the company have Visionary Leadership?
Could it 10X in 10 Years?
Well, Bitcoin is not a company, but despite that difference, the same mental model holds. I believe Bitcoin is an emerging Maverick. Let’s explore why.
Note: This investment carries different risks than the typical Maverick, because Bitcoin isn’t a cash producing asset. That said, it fits the return profile we’re looking for when investing in Mavericks.
What is Bitcoin?
Bitcoin is a break-through in Computer Science. It uses cryptography to establish Trust between unknown parties over the Internet.
So What’s the Big Deal?
Today, in order to perform financial transactions, we need to trust several intermediaries, be they lawyers, escrow services, banks, even governments. With Bitcoin, you simply need to trust Math. There is no middle man. And there are no fees (ok, minimal fees).
Bitcoin gives us the ability to transfer any digital asset (think digital signatures, digital keys, digital representations of physical things, or even digital money) from one Internet user to another, in a guaranteed, safe and secure way, where everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. That’s groundbreaking!
Bitcoin Is Also Scarce
Historically, Bitcoin has been a very volatile asset, and it has appreciated significantly over the past 5 years. As a result, people do not really use it as a form of money. Instead they use it as a store of value, like gold.
Here is an excerpt about this from Fred Wilson, a prominent VC, where he talks about how he gave a $5000 gift in Bitcoin, 142 Bitcoins at the time. At today’s prices, that gift is now worth almost $1.4 Million! Oops!
“I share these transactions with all of you to make a point.
And that point is that you can’t keep spending something that goes up as much as Bitcoin has.
So I don’t spend Bitcoin anymore.
I hold it.
It’s a store of value now.”
— Fred Wilson
Ironically, like Gold, Bitcoin is also produced by mining. In the case of Bitcoin however, they are mined by computers solving complex mathematical problems. Once a problem is solved, Bitcoins are unlocked. These math problems get significantly harder over time. Also, the math problems also unlock fewer and fewer bitcoins over time. As a result, just like gold is scarce, so is Bitcoin. In fact, there is a hard limit. Over time, only 21 million Bitcoins will ever be created.
With that background, let’s explore our checklist.
Is Bitcoin a Leader in a Large Growing Market?
Yes!
Today, all cryptocurrencies (Crypto) combined are worth about $267 Billion. The growth in Crypto has been incredible. To put things into perspective, 5 years ago the total market size was less than $10 Billion!
And Bitcoin is the standout leader of the group. The orange below represents the percent of total Crypto Market Cap represented by Bitcoin. It currently sits above 60%!
Crypto is clearly a Bitcoin story.
Bitcoin transactions also continue to grow. Daily transactions currently sit around 300,000. What’s interesting to see is that the high in daily transactions was in 2019 not in 2017 when bitcoin prices peaked. Daily transactions have rebounded faster than price. This is bullish.
Lastly, the amount of activity in the crypto-ecosystem has continued to increase:
People used to mine bitcoin on their personal computers. Today, there are sophisticated clusters of machines and data centers trying to do this faster and better than others.
Venture Capital continues to pour into the space, and the crypto developer ecosystem is vibrant and well.
We have seen early signs of the emergence of new bitcoin specific products and companies. For example, we have secure hardware wallets to store bitcoins and other cryptocurrencies. We have stable exchanges like Coinbase to buy and sell such currencies. We have a major mainstream app (Square’s Cash app) that lets you deposit bitcoins (By the way Arpit, when are you going to write that guest post on Square? It certainly is a Maverick as well). We’ve even had a few failed attempts at bitcoin ETFs.
This all leads me to believe that Crypto (as an asset class) is here to stay. That’s the leap of faith you need to make in order to invest in Bitcoin: believing the Crypto market cap will continue to grow significantly.
Such leaps of faith are nothing new. When a new technology emerges, if it is significantly better, cheaper, faster and more accessible, it eventually goes mainstream. Products, companies and industries emerge to commercialize it. Its effects are felt by millions of people, and later, many wonder why its powerful promise wasn’t more obvious from the start.
Does Bitcoin have a Growing Competitive Advantage?
Yes, I believe so.
Bitcoin Simply Doesn’t Seem to Die
This may not seem like much, but there have been plenty of opportunities for Bitcoin to die:
Multiple Hacks
Multiple Massive Price Declines
Multiple new and improved Crypto currencies created
But it continues to survive.
“Great companies have secrets: specific reasons for success that other people don't see”
— Peter Thiel
Bitcoin has such secrets as well, which continue to let it survive, again and again and again...
The Bitcoin Network Effects
Bitcoin is a classic network effect: The more people who use Bitcoin, the more valuable Bitcoin is for everyone who uses it, and the higher the incentive for the next user to start using it.
Bitcoin has a four-sided network effect:
People who own it or pay for things with it
Merchants who accept Bitcoin
Miners who run the computers that enable the distributed trust network to exist
Developers and entrepreneurs who are building new products and services with Bitcoin, or on top of Bitcoin
All four sides of the network effect are playing an important part in expanding the value of the overall ecosystem, but the fourth is particularly important. Without developers and entrepreneurs, the innovation would stop.
The longer this continues, the stronger the network effect becomes.
It’s been 10+ years and counting.
The Bitcoin Brand: The FICO-Score Affect
It no longer matters whether Bitcoin is the best crypto-currency or whether it has the best underlying technology.
Bitcoin is THE established brand in the Crypto world. It has “crossed the chasm”. For the layman, Bitcoin is actually synonymous with Crypto. Bitcoin is the barometer that everything else in the Crypto-world is compared to. This is very powerful and should help Bitcoin remain relevant.
I compare this to the FICO Score. In the US, lenders use FICO scores to gauge a potential borrower's creditworthiness. The way the score is calculated isn’t known. Many argue that at best it is old and outdated and doesn’t best represent a borrower’s creditworthiness. That clearly doesn’t matter. FICO is the accepted standard. I believe Bitcoin will remain the accepted standard in the Crypto-world.
Winners Keep Winning: The Power Law in Effect
If the X-axis represents investment options, and the Y-axis investment returns, when it comes to investing in radical innovation, a small number of investments account for a large proportion of total returns. The Power law distribution exhibits “fat tails” compared to the area under a normal distribution curve which falls off much faster as you move farther along the X-axis.
The Power Law is difficult to grasp. Once it becomes apparent that certain technologies or companies have massive network effects or competitive advantages, and even if everyone is aware of them, people still fail to recognize the magnitude of these companies’ future returns. Take Google for example. When it became obvious how dominant it was, even if you bought it at a $100 Billion valuation, you would still have made a 10X! You just had to ensure that the market opportunities were big enough.
A successful investment in radical innovation is a successful bet on the power law. That is the biggest secret in venture capital, that the best investment in a successful VC fund equals or outperforms the entire rest of the fund combined. I believe Bitcoin is exhibiting Power Law dynamics and this alone is a good reason to bet on Bitcoin. As I’ve said before, Investing in Mavericks is like investing in Venture Capital.
Therefore, if you believe the Crypto market will be significantly bigger in 10, 15, 20 years, then betting on Bitcoin is a bet on the Power Law. Bitcoin is the clear winner in Crypto so far, and per the power law, it should keep on winning.
In life, winners keep winning.
Betting on Bitcoin is like betting on Usain Bolt (the world’s fastest man) mid-race. He’s already in the lead, and is likely to win.
Bitcoin is Also a Hedge
Bitcoin disadvantages entrenched interests. Bitcoin may allow individuals to access capital easier, transact cheaper, and not get cheated along the way:
Why keep money in a currency that has a history of devaluation?
Why keep money in a bank that may seize it?
Why give money to a bank that may make bad bets with it (derivatives during the financial crisis)?
Financial assets are correlated. We saw this during the financial crisis. If there is another major shock to the system, we could see such correlation emerge once again. Bitcoin however seems to be a lot less correlated to these other assets.
It is for the above reasons that I believe Bitcoin is well positioned to maintain its dominant position in the growing crypto market. As such, it has the makings of a successful Maverick.
In Part 2, we will cover the remainder of the above checklist:
Bitcoin may be part of the Lindy Effect and the Power Law, but how hard can it handle the Thucydides Trap and win? (see: ETH and related systems)