November 2018 Commentary

May 11, 2020

November was worst performing month for the IC fund portfolio. But in blockchain assets, this is par for the course. We should expect periodic drawdowns of 80%. My conviction in bitcoin has been growing steadily since 2014. In times like these, we should remember that bitcoin has been best performing asset over the last 10 years. It has experienced 1,300,00X increase in value from $0.003 to ~$4000 today. It has beaten S&P 500 in the last 10 years, last 5 years and even last 2 years. As a fixed supply asset, I believe it will outperform other asset classes as the demand continues to rise. Since the supply is fixed and inelastic, with increasing demand it will push the price up, just following the first principles of economics.

I watch number of metrics with respect to the growth of Bitcoin’s network. These are mainly, Hash Rate of the network, number of users’ growth and the transaction value on the bitcoin network. What I found interesting is that bitcoin hash rate started dropping since the last one month. That is a very good sign of the bottom.

This Hash rate used to be as high as 53 Exa hashes (53 X 1018) in September 9th, 2018. It dropped down currently to 38 Exa Hashes (38 X 1018) per second. If you watch closely hash rate has dropped by any significant amount only once before, which was around September 1, 2011. On that day bitcoin network’s Hash rate was around 14 Tera Hashes (14 X 1012 ) per second. It dropped slowly to 7.5 Tera hashes( 7.5 X 1012 ) by November 24th, 2011.That was a huge drop. If you look back at the price of bitcoin on November 24th, 2011, you will notice that it was around $2.38. The price has fallen almost by 94% by dropping from $32 to $2. Since that time, this is the first time we have seen a steady drop in the Hash rate. If past was any guide, this is a great time to buy bitcoin.

This begs the question, what is the significance of Hash rate? Hash rate indicates the amount of energy and capital that an adversary to bitcoin has to spend, in order to execute a 51% attack. The more Hash power that goes to secure the network, that harder it is for Sovereign nations or any malicious actors to attack the Bitcoin network.

As an analogy, let us say I leave a $100 bill on a table and walk way and leave that table open for anyone to steal my money. If I don’t guard it, someone will naturally steal my $100 bill. If I want security for my money, I will make sure to post a security guard.  What does posting a guard do? If someone has to steal my money, they have to expend some physical energy and defeat my security guard and only then they can steal my money.  Assume now that, on the same table I want to leave 1 billion dollars. Will I still have just one security guard protecting my money? No. Of course not. As the value of my money keeps going up, I need bigger security. I would expect may be 50 security guards if I am storing 1 million dollars and may demand 1000 security guards, If I have 1 billion dollars.  If the place which is protecting my money only has 50 security guards, I will be open to storing only 1 million dollars. Why would anyone risk their billion dollars if there are not enough guards protecting money from adversaries? The bigger the amount you want to store, the bigger the security you need to ensure that no one can steal this money. The amount of money you can store in Bitcoin network is directly proportional to the hash power, that goes to secure it. Hash power cannot consume all electricity in the world, but it will continue to grow slowly as the bitcoin’s valuation goes into trillions.

 Bitcoin miners are effectively these security guards, who perform the task of protecting this money, so that they get rewarded in bitcoins for securing this network. They invest their own capital to maintain these data centers and spend their own fiat money on the electricity in order to receive rewards in the form of coinbase rewards. Bitcoin miners provide this security service, which is a commodity service. Anybody can join this permission-less network and find the cheapest form energy that is available to them and compete globally with everyone to provide security to the bitcoin network. This industry is extremely competitive where the rates simply head to zero. It is a commodity business. For example, a pound of copper produced by one miner is identical to the pound of copper produced by another. Nothing actually differentiates a pound of copper as an industrial commodity. If left to free markets, the producer who has the cheapest marginal production costs wins this market. Hash rate is a commodity that is produced by these Bitcoin miners and supplied to secure the Bitcoin network, in order to receive bitcoins as the reward for their services.

What is really interesting is that as new unprofitable bitcoin miners leave the network, bitcoin has an interesting idea called, “difficulty adjustment”.  The basic idea is that no matter how many bitcoin miners are collectively working together to produce bitcoins, the emission rate of the bitcoin is set to generate a new block every 10 minutes on an average. If miners leave the network, difficulty algorithm becomes easier after every 2016 blocks.  If new miners join the network, it makes the difficulty of finding the hash for the new block harder. It is quite remarkable because no matter how much energy humanity spends on mining bitcoin, it will not produce more bitcoins. If humans collectively spend more energy to find gold, we can increase the supply of gold. If we spend more energy and time, in producing new cars, we can produce more. If fiat money is demanded more, we know we can produce more of it. If we want to produce more goods of any kind, we can always make more, with the singular exception of bitcoin. That is what makes bitcoin very unique kind of commodity than anything else in the world.

Bitcoin mining difficulty adjustment

Bitcoin’s immutable monetary policy ensures that people are incentivized to store their money in this network. When people view, bitcoin as a store-of-value, it automatically increases the demand bitcoin, and it increase bitcoin price. Higher prices will make bitcoin mining more profitable. This will encourage other people to start mining bitcoin. When new miners join the network, it does NOT make more bitcoins to be produced. Instead of producing more bitcoins, the difficulty algorithm becomes harder and continues the produce the same quantity of bitcoins as before. So currently this figure is set to be 12.5 bitcoins every 10 minutes.

By having a larger number of miners than before makes the bitcoin last longer and makes it more secure. Therefore, it incentivizes the new users to store more money in the network.

In case of all other commodities known tomankind, as the price rises, it automatically brings new entrepreneurs to produce more of that commodity and consequently bring the price down. In case of bitcoin, what we are experiencing today is a very rare phenomenon. When the price has dropped so much that it is no longer profitable for a big chunk of miners who closed their data centers. This does not lead to a death spiral because, as miners leave the hash rate falls. When hash rate falls, the difficulty adjustment becomes easier, but it will continue to produce bitcoins at the same rate. This will help stabilize the price and keep the feedback loop working. This process has started 1 month ago as many miners started shutting down their data centers as it costs at least $4500 in electricity to produce a bitcoin for many marginal producers of bitcoin.

For new comers to bitcoin, this process sounds crazy. Why are we trying to solve a difficult problem that is computationally very difficult and running close to 7 trillion laptops (total power consumed by the network) every second? That is the price we pay for an immutable ledger that cannot be controlled by any single individual or company or government. If someone needs to perform 51% attack on bitcoin network, they need to prepare to spend an enormous amount of capital in terms of setting up data centers and spend fiat money in order to successfully attack the network. All of the power of bitcoin comes from the fact that it has an immutable monetary policy, that is not controlled by any government. If someone is able to control the money supply of bitcoin, then I would say bitcoin’s value will head to zero very quickly. That is the fundamental problem faced by the entire world today with central banks controlling our money supply. Bitcoin removes the centralized trust via proof-of-work ensuring that no one can bypass the consensus rules.

As long as bitcoin can prove to the world that it has an immutable monetary policy, it will drain value from all asset classes like gold, fiat money, stocks and real estate into itself, just as water flows downhill following gravity.

Managing Partner