Bitcoin Economics 101
Bitcoin was originally designed to be used as “digital cash”.
Now, there is so much more to it — being argued to be a store of value, means of exchange and a payment method.
Delve into the economics of Bitcoin in this article.
Bitcoin's Tokenomics
The tokenomics and inner workings of Bitcoin and the Bitcoin cryptocurrency were outlined in Satoshi Nakamoto's Bitcoin whitepaper, "Bitcoin: A Peer-to-Peer Electronic Cash System".
Bitcoin has a limited total supply of 21 million tokens, with the circulating supply increasing as miners create new blocks and verify Bitcoin transactions. Using a Proof of Work (PoW) consensus, Bitcoin miners commit significant computational power to the network to solve complex mathematical problems. The first miner to complete the problem validates the block of transactions and is granted a reward in the form of newly minted Bitcoin (BTC).
Every 210,000 blocks, the mining reward for creating a new block is cut in half – this process is referred to as the Bitcoin halving. The difficulty of Bitcoin's cryptographic puzzles is automatically adjusted to maintain a consistent block creation time of approximately ten minutes. This difficulty adjustment means that a Bitcoin halving occurs roughly once every four years.
Bitcoin's Intended Use Cases
Initially, Bitcoin was created as a peer-to-peer version of electronic cash. In the Bitcoin whitepaper, Nakamoto writes that electronic cash "would allow online payments to be sent directly from one party to another without going through a financial institution".
Bitcoin was designed to provide a trustless payment system that would allow two parties – for example, a merchant and a customer – to transact directly with one another, without needing to rely on third-party intermediaries.
Bitcoin as a Payment Method
Fundamentally, Bitcoin acts as a payment method with enhanced trust and security. Bitcoin's chain of ownership is verified by digital signatures, while the Proof of Work consensus mechanism helps to secure the network and avoid double-spending.
Bitcoin nodes are used to verify transactions without interference from third-parties. Acting in a decentralized manner, Bitcoin requires agreement from the majority of nodes, thus eliminating single points of failure.
More recently, the Bitcoin Lightning Network (and other Bitcoin Layer 2 blockchains) have been introduced with the intention of increasing transaction speeds, making Bitcoin's use as a payment method more feasible than ever.
Bitcoin as a Means of Exchange
Bitcoin is also widely viewed as a means of exchange. A means (or medium) of exchange is something that is primarily used within an economy to facilitate the exchange of other goods and services.
Bitcoin has significant potential as a means of exchange due to the fact that it's inflationary-resistant, with a fixed total supply, and is considered "hard money", meaning that it's difficult to produce new units.
Bitcoin may not have yet experienced mainstream adoption in the same way that more established means have, but something can still act as a medium of exchange without needing to be used in day-to-day transactions.
According to Gresham's Law, "Bad money drives out good". When two currencies exist, individuals will spend that which is constantly devaluing – in this instance, the US dollar – and hold that which retains value – for example, Bitcoin.
For example, in September 2021, El Salvador became the first country in the world to make Bitcoin legal tender.
Bitcoin as a Store of Value
Many individuals (and institutions) also consider Bitcoin to be a store of value. When looking at Bitcoin's price history, it's clear that Bitcoin has significantly outperformed most other investment vehicles over the past decade. In fact, according to CoinGecko (as of December 2024), the ten-year price growth of the world's most popular assets were as follows:
- Bitcoin – 26,931%
- S&P500 – 193.3%
- Gold – 125.80%
- Crude Oil – 4.3%
Is Bitcoin a Currency?
Professional opinion about Bitcoin being a currency is divided. A currency needs to be:
- A store of value
- Medium of exchange
- A unit of account
There are arguments both for and against Bitcoin being a currency. According to Markus Willms, member of the European Investment Bank, Bitcoin does meet the above criteria. However, David Yermack, writing for the Handbook of Digital Currency: Bitcoin, Innovation, Financial Instruments, and Big Data, claims that Bitcoin largely "fails" to do so.
Conclusion
The economics of Bitcoin continue to have divided opinion. Some argue that it is a means of exchange, a store of value, a viable payment method and a genuine (albeit digital) currency. While some disagree with the aforementioned.
Regardless, at Prosper, we believe that Bitcoin will continue to revolutionize the world of finance.
