ECON120: Monetary History

Tulips

During the seventeenth century and a few decades after the founding of the Bank of Amsterdam, a speculative price bubble occurred in Dutch tulip bulbs. As a beautiful luxury item, tulips became all the rage in the Netherlands as everybody wanted a piece of the highly coveted commodity. Prices of bulbs exploded and then collapsed shortly there- after, as all speculative bubbles do. The word bubble would be used throughout history to describe increases in the price of an asset that seemed unfathomable to many, increases that would unquestionably and consistently end in ruinous decline. Of course, many have fruitlessly tried to associate the word bubble with Bitcoin.

Bitcoin's exponential price rise since its birth continues to bring about cries of a bubble and comparisons to Dutch tulips despite having fully recovered from intimidating 80% price declines now on three separate occasions. The BTC/ USD price is breathtakingly volatile, far outstretching price fluctuations we typically see across other asset classes. Its volatility, however, is not a reflection of asset quality or even excellence. If Bitcoin truly is to grow from an adolescent monetary network to the basis of an international monetary system, surely the ups and downs on its way will mimic a formidable rollercoaster. If the market value of BTC were to equal the market value of all the world's gold, the BTC/ USD price would reach approximately $500,000. It is safe to assume that the journey from less than $1 to $500,000 would come with its fair share of frenetic price swings, both up and down. These vacillations are ingrained into Bitcoin's maturation and will separate early adopters from those who will wait for the price to stabilize in USD terms. None of this volatility, however, precludes BTC from being a store of value and an alternative to currencies based on aging archetypes.

In reality, Bitcoin is nothing like the Dutch tulip mania. Bubbles don't burst three times in a decade and come back stronger each resurgence, and the investing public is finally waking up to this fact. In 2020, some of the most legendary hedge fund investors of this generation, Paul Tudor Jones and Stanley Druckenmiller, acknowledged ownership of BTC. Investment management powerhouses such as AllianceBernstein, Blackrock, and Fidelity Investments made public recommendations for clients to have BTC in their portfolios as a hedge against the devaluation or demise of government currencies. PayPal, the world's largest online payment processor, gave its 300 million global customers the ability to purchase BTC on its platform. It began to become clear to the investing community that denying Bitcoin's place in the future of money was like denying the Internet's place in the future of commerce in 1999. Internet stocks might have experienced a speculative price bubble at the turn of the twenty-first century, but the world's biggest publicly traded corporations today are Microsoft, Apple, Amazon, Alphabet (Google), and Facebook, which have generated trillions of dollars in market value thanks to the Internet.

The flurry of endorsements preceded the BTC/USD price reaching a new all-time high at the beginning of 2021 as the total market value eclipsed $600 billion. What was once a digital token attached to a hobbyist software worth less than a penny in 2010 had become a $34,000 commodity only a decade later. The famous $25 Papa John's pizza trade would be worth $340 million on Bitcoin's twelfth birthday, January 3, 2021. Figure 15 shows the meteoric rise in BTC's total market value since 2010.

Figure 15

Lightning Network

Lightning Network is a technological enhancement to Bitcoin that positively transforms it from a slower-moving commodity like physical gold to a currency moving at lightspeed. And the key ingredient to the Lightning Network is the smart contract. Generally, smart contracts are programmable agreements capable of anything that can be coded into software. For the objective of Bitcoin, smart contracts are most importantly capable of escrow and multiple-party coordination. The smart contracts in Lightning Network, Hashed TimeLock Contracts (HTLCs), have scaled Bitcoin into a monetary network capable of processing millions of transactions per second. Let's take a closer look at how Lightning Network evolved.

In the first couple years of the Bitcoin network, a small contingent of Bitcoin enthusiasts contributed their own ideas and improvements to the project. They fixed some critical vulnerabilities that could have abruptly ended the network before it caught momentum. These software engineers and cryptographers worked on Bitcoin because they had conviction in the technology, owned BTC, and wanted the net- work to succeed. They weren't receiving an income from any employer; they were working out of belief in a new denomination. Over the years, they graduated Bitcoin from a project to a legitimate global monetary network.

The most crucial updates that transitioned Bitcoin to a smart contract platform occurred from 2015 to 2017. These Bitcoin Improvement Proposals (BIPs) turned one-dimensional Bitcoin transactions into wildly customizable financial contracts, without changing any of Bitcoin's fundamental rules.

In 2016, a paper from software engineers Joseph Poon and Thaddeus Dryja called "The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments" built upon all the smart contract innovation happening on the Bitcoin soft- ware. The paper was a proposal for a new type of Bitcoin smart contract (HTLCs) that enabled instantly settling payments without having to wait for the next block to be mined. Lightning Network not only infinitely increases Bitcoin's capability as a medium of exchange but also allows for innovations such as paying for online streaming by the millisecond. And in the digital age of streaming everything, why shouldn't money stream as well?

Lightning Network also brings a new dimension to the time value of BTC. Users that provide BTC as collateral to Lightning Network in order to facilitate transactions can potentially earn income from providing this liquidity. This is a historically unprecedented way to earn a return on capital without ever relinquishing custody of it because collateral providers don't actually part ways with their BTC when dedicating it to Lightning Network. Interest rates derived from this type of activity could function as a reference rate in the Bitcoin world because of Lightning Network's uniquely counterparty-free nature. The very concept of the time value of money is changing as these new technologies permeate the monetary landscape.

Figure 16

Source: Nik Bhatia: Layered Money
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