What follows is the first of a four-part series of essays aimed at sharing the options team's perspective and thoughts on Bitcoin and what they see as its enduring place in the expanding realms of digital assets.
“When did you start believing in Bitcoin (or digital assets in general) as a ‘real’ investment opportunity?”
This is a question we in the Option Group are increasingly facing from both colleagues and clients.
First, let’s differentiate between investing in companies that are going to develop the digital asset industry, and investing directly in digital assets. In this case, we are talking about the latter.
So, when did we become believers? In the beginning, like many, we found it difficult to appreciate what we now see as the elegant durability of Bitcoin, due to its relatively isolated existence. What changed was that we began to fully appreciate what we view as the uniqueness of the Bitcoin innovation when we started researching competing digital blockchains (coins, tokens) like Ethereum, Cardano, Tether or Solana, to name a few.
Bitcoin Mining, Simplified
Bitcoin mining is the process of building new ‘blocks’ on the public Bitcoin blockchain. To build a block, Bitcoin miners solve complex cryptographic equations that meet specified parameters. By adjusting these parameters after a set number of blocks, the mining process can be sped up or slowed down to target an average production time of 10 minutes per block. As the network’s mining power increases, Bitcoin blocks become harder to mine, and vice versa.
Each time a new block is built, the miner earns two sources of revenue: One for building the block, and a second for validating the set of transactions submitted to the Bitcoin network for memorialization on the block the miner has generated. Miners that can deploy more energy tend to mine more blocks over time and earn higher mining fees as a result—although it’s important to remember that profits are a function of mining fees minus energy—and equipment-based operating costs.
Hence, Bitcoin mining should trend toward equilibriums that balance the current needs of the network. If mining is abnormally profitable and attracts a lot of new miners, mining difficulty will increase and profitability will decline, thus limiting the growth of energy consumption for mining. When all Bitcoins have been mined, the network will scale down to the energy needed to simply validate transactions.
Shades of Decentralization
Bitcoin operates on a decentralized ledger (the blockchain) that is maintained by a network of computer nodes (the miners or validators). A simple metaphor we have adopted from computer scientist Nadav Kohen describes the blockchain as a tall skyscraper. Each floor is a unique block that can store (lock) information transaction records, program code and other information. Once a floor is built, it is basically impossible to remove or change the floors below. In essence, decentralized mining nodes store the blueprints for the building, so that everyone on the network can agree upon how the building is constructed and what is on each floor.
In the case of Bitcoin, almost all mining nodes maintain a copy of Bitcoin’s full blockchain (the blueprint for the Bitcoin skyscraper), allowing them to recreate any records or any point-in-time view over the full, 10-year history of Bitcoin. At present, Bitcoin’s blockchain contains roughly 400 gigabytes of data, allowing these full “core nodes” to be run on a relatively standard desktop computer. Compare that with Ethereum, which has amassed a blockchain of over 2.5 terabytes in six years. As a result, most of Ethereum’s “archive nodes”—the ones that have the full blueprint—are run in the cloud.
The important point is that while Ethereum can claim to have as many or more mining nodes than Bitcoin, only a handful maintain a full record of Ethereum’s blockchain, which means most are trusting a few archive nodes that maintain the full record. This scaling challenge has led the Ethereum network to create 64 “shards” that divide the blockchain into more manageable chunks.
Proof of Work Versus Proof of Stake
Both Bitcoin and Ethereum began by using proof-of-work (“PoW”) blockchain validation. This simply means that the miners who do more “work”—which equates directly to expending the increased energy with increased hardware to achieve the more computational power to validate the blocks on the blockchain—are the ones who earn greater profits. In response, many miners will pool resources to create more efficient operations and share profits.
Meanwhile, Ethereum recently adopted a plan to switch to a proof-of-stake (“PoS”) validation. In a PoS network, validators are required to stake a certain number of coins to back their commitment to operating as a trusted validator. Malicious validators forfeit their stakes. Whereas miners in a PoW network compete to generate the next block, Ethereum’s PoS network randomly assigns validators work based on their stake. PoS is also compatible with the “sharding” of the Ethereum blockchain.
To summarize, building and running a competitive Bitcoin mining operation that will earn profits based on its power and efficiency requires capital expenditures and comes with operating costs. Miners that innovate and invest in systems can earn more profits. In contrast, Ethereum validators are then randomly awarded transactions, and thereby profits, based on the size of their stakes, meaning those with the most money keep earning the most profits. We believe the PoW methodology promotes more innovation (because profits are a function of mining efficiency) and is less likely to dominated by a handful of stakeholders with the most capital (such as big banks).
We hope the philosophical differences between these two approaches are clear. There are Bitcoin miners that do “the work” for profits (“Main Street”), while Ethereum validators simply put up their “money” to make more money (“Wall Street”). We find this to be a particularly ironic contrast in our current socially aware environment.
The Tortoise Versus the Hare
The other major distinction between Bitcoin and other blockchains is transaction speed. Bitcoin was founded with a predetermined finite quantity and designed to ensure that a new block is created at standard intervals, roughly every 10 minutes. There are several reasons for these restrictions.
First, Bitcoin is technically “over-secured” relative to other blockchains. While Bitcoin follows similar cryptography methods, it adheres to a more stringent rule set that ensures blocks take a specific time (10 minutes) to mine. This, in turn, slows the validation process and provides ample time for a population of global miners to validate and agree on new transaction blocks. Second, promoting a scarcity value helps ensure miners can be rewarded as Bitcoin’s coinbase grows. Third, in our opinion, the Bitcoin blockchain is not intended to be a purely transactional platform. Rather, it’s more like realestate, physical precious metals/gems and antiques that are not traded in a matter of seconds. In the end, we think Bitcoin transactions will likely be dominated by larger global payment transfers with only a small fraction of its volume being smaller higher frequency transactions, so that perhaps 20% of the transactions will comprise 80% of the volume.
We have omitted many details, but the general theme is that Bitcoin is an innovation that intentionally sacrifices transactional speed for simplicity, stability, durability and uniqueness. In contrast, in our view, new entrants like Ethereum have chosen to compete on efficiency, flexibility and ubiquity. In our minds, Ethereum is therefore not a “true” competitor to Bitcoin.
Layering Versus Native Functionality
Trying to be all things to all people tends to be a short-term strategy. In competitive markets, specialization tends to promote long-term success. To this end, we believe Bitcoin’s narrow focus and defined capacity favor it as a long-term digital solution.
However, that does not prevent it from gaining scale and competing with more recent iterations of blockchains. Rather than making various features native to the blockchain methodology, as Ethereum does with smart contracts, Bitcoin adapts and expands its utility by adding on technology layers. Bitcoin’s Lightning network is one example of this, which allows small Bitcoin transactions to occur in minimal time. If Bitcoin is the ‘cheese pizza’ of the digital asset ecosystem onto which any number of toppings can be added, Ethereum is more akin to a stuffed calzone, with the additional flavors baked in.
A challenge for Bitcoin is that developers need to build those layers. With some uncertainty around Bitcoin’s role in the digital asset ecosystem, we expect the development of additional layers to take time. Returning to our building analogy, Bitcoin’s blockchain was dug deep into the ground to create a foundation for a skyscraper and is just now starting to finish floors above ground. Meanwhile, other developers are already finishing smaller buildings surrounding Bitcoin’s building site and have started taking tenants and advertising new amenities. Over the longterm, the flexibility of other blockchains may ultimately limit their adoption as “assets,” as investors, brokers, clearing houses and custodians grow weary of adapting systems to constantly evolving blockchains. One of the most important characteristics for building a robust financial product ecosystem is the stability and standardization of the underlying asset or exposures—things we believe Bitcoin, with its unchanging blockchain, will provide. Repeatedly canceling and replacing digital coins for upgrades, such as the Ethereum “sharding” mentioned earlier, may be “seamless” in technology terms, but it may prove burdensome given the rigors of institutional investors.
The success of Bitcoin was inevitably going to attract competition. Market participants certainly can’t resist the near-zero barriers to entry to compete with Bitcoin’s “obvious” flaws. Yet, in doing so, we believe other cryptocurrencies continue to shift away from the foundational advantages of Bitcoin and toward something more akin to opensource technology platforms or full-fledged applications.
These can have great utility. Many wrap Bitcoin transactions in Ethereum smart contracts to speed transactions or augment payment terms, for example. We have seen smart contracts on a “private” blockchain used to issue corporate debt—digital bonds, effectively, which offer direct chains of custody and are easily traded and divisible. Investment banks appear eager to offer clients the ability to access capital through new digital assets in this way, which could have significant implications for investment banking deal flow. Further, their validating networks could earn transaction fees for confirming trades on the bond’s blockchain.
In contrast, we believe Bitcoin will remain the relatively simple, immutable digital asset it is today, and over time, we expect the fundamental differences between Bitcoin and other cryptocurrencies to continue to push their use cases further apart. Methodology upgrades and “forks,” such as Bitcoin’s Taproot and Ethereum’s Ether 2.0, will create new points of divergence. Keys to Bitcoin’s widespread adoption as a true digital asset will be the continuity or backward-compatibility it has exhibited to date and its relative stability within the digital asset universe. Its narrow focus and stable foundations are what make it a logical choice for wide adoption.
Laying the First Block
In the late 1990s many internet companies went on to become enduring franchises while others flamed out in spectacular fashion. We expect nothing less over the course of the “blockchain revolution.” Network effects will reinforce consensus-building in a select group of digital blockchains as more nodes attract future nodes, similar to how a handful of large tech companies have built massive, durable networks with relatively simple application platforms.
For us, Bitcoin’s amalgamation of attractive attributes in combination with its straightforward implementation of blockchain technology, makes it uniquely situated as a ‘cornerstone’ digital asset.