What is bitcoin backed by?

Tuesday 15 July 2014

We know the idea behind proof-of-work, the process by which new transactions are verified and added to the blockchain. The energy-intensive work of miners provides a costly and hard-to-fake proof that no fraud has been committed. It’s a beautiful solution to the double-spend problem, also known as the Byzantine Generals puzzle. But does it mean that bitcoin is ‘backed’ by energy, as some have claimed – and if so, what does that mean for the currency?

TL;DR: bitcoin isn’t backed by energy. It’s backed by bitcoiners.

bitcoin algorithmLike so much about bitcoin, mining is simple in theory but extremely complicated in the detail. As a quick-and-dirty recap, miners secure the bitcoin network and add new transactions to the blockchain, bitcoin’s decentralised ledger. The new transactions are verified by including a ‘proof of work’ with the latest block. This essentially means that the miner that adds the block has carried out an extremely difficult mathematical puzzle – one so difficult that it takes tens of thousands of specialised chips running trillions of calculations per second each around ten minutes to find. The ‘work’ proves the block is valid, because anyone who wants to falsify the blockchain in their favour not only has to recreate that proof, but do so before the next block is added by the next miner and they fall hopelessly behind.

As a result, mining is a highly energy-intensive business. It’s that energy consumption – consumed in a particular way – that keeps the bitcoin network secure. But there are plenty of questions and misconceptions surrounding that energy use. This article unpacks one of them: the curious idea that bitcoin is ‘backed’ by energy.

Backing a currency
Traditionally, currencies were backed by something tangible and valuable – often gold. A banknote was really a promise that the bearer could exchange it for a certain amount of gold, equal to the face value of the note. This is known as commodity money.

When governments left the gold standard and their currencies were no longer backed by precious metal, they were instead backed simply by the promise that the state would enforce the value of the money. ‘State-backed’ simply means that the government decrees it has value. This is why it is commonly known as fiat money, from the Latin word ‘fiat’ meaning ‘let it be so’ (as anyone who has watched Star Trek in Latin will instantly recognise). Fiat banknotes have no value of their own: they are paper. Their value derives from the recognition that the government says they can be exchanged for goods and services.

So what makes bitcoin valuable?

Currency value

bitcoin miningCryptocurrencies manifestly aren’t fiat money: one of their most important features is that there is no state to issue them. They are created, in most cases, by mining (you can read up a little on proof-of-stake here, which has other implications for currency creation and network security). Bitcoiners often distinguish crypto money from fiat money, recognising their different natures. But neither are cryptocurrencies backed by precious metals, or any tangible material.

The scarcity, attractiveness and chemical stability of gold (and, to a lesser extent, silver) gives these materials value and makes them a suitable medium of exchange. The work it takes to dig them out of the ground and refine them can be compared to the work done to mine a bitcoin by carrying out trillions upon trillions of hashes – the relevant mathematical puzzle – in order to find just one that meets the right criteria every 10 minutes.

That enormous energy consumption reflects the work done to keep the bitcoin network secure, and the security of the network is one of the things that conveys value to bitcoin.

Somehow, however, these facts have become conflated in the popular mind, and there is a pervasive idea that bitcoin is somehow ‘backed by energy’.

This is typically an argument that is put forward against other systems, such as proof-of-stake: that the consumption of energy shows that bitcoin is ‘worth’ something, and that a cryptocurrency that does not use this system – or that does not cost anything to run – is therefore worthless.

This is a superficially attractive concept (cost incurred leads to value), but that conflation of ideas leads to the fallacy that bitcoin’s value ultimately derives from the energy expended to mine it. The reductio ad absurdum is that the more hopelessly inefficient miners we have, the more valuable bitcoin will be. In fact, the reverse is true: all things being equal, miners will join the network and expend energy when bitcoin’s value is higher. The more efficiently they can mine, the less energy they will expend and the greater their profits.

Energy tokens?
In the context of bitcoin, you will no doubt have heard the argument that money needs to fulfil three purposes: it is a store of value, a unit of account and a medium of exchange. Bitcoin excels at the third but its volatility means it is currently poor at the first and second. Nevertheless, it does store value, and the question once again arises of what gives a currency its value, regardless of the degree to which it maintains it.

Traditional money is either valuable because a government says it is (fiat) or – more convincingly – because it stands for something that is valuable, like gold. Bitcoin doesn’t stand for anything else.

It’s not backed by anything. As ‘lightspeed’, one critic from the crypto forums, puts it, ‘The argument about energy “backing” Bitcoin is flawed because Bitcoin doesn’t need any backing. People do not hold bitcoin as energy tokens.’

(As an aside, it’s worth considering for a moment the wealth and breadth of expertise on such forums. There is nowhere on earth, with the possible exception of the House of Commons, where it is possible to find such a diverse mixture of genius, raw and trained talent, experience, educated and uneducated opinion, strident disagreement and rampant trolling.)

Bitcoin value
Backed by goldTo explain this further, imagine that a currency – whether bitcoin or any other medium of exchange – is backed by something genuinely useful (such as energy or food). If it had such value, it would eventually be removed from circulation to be put to that use. Gold is almost useless for any practical purpose. We like it because it is shiny and doesn’t corrode, but you can’t eat it or burn it. The fact that it has recently found application in electronic products doesn’t make it more valuable as a means of exchange. It makes it less so. Think what would happen if gold suddenly became vital for some important device – we would exchange it for something else to free it up for that use. As lightspeed notes in the same post, you don’t want your money to have intrinsic value: ‘anything that needs to function well as a monetary medium needs to have as little utility – or intrinsic – value as possible.’

There are a handful of properties that make something useful as a currency. It needs to be scarce, otherwise you will need a lot of it to buy anything. This is one reason that gold was used for so long. It needs to be divisible – again, one of gold and silver’s advantages. They could be made into coins of differing weights. It needs to be hard to counterfeit and easy to recognise. And it needs to be fungible, or easy to substitute for another unit of itself: one gold coin is much like another.

Bitcoin: perfect money?
Bitcoin matches all of these properties, and does so far better than gold. But that’s not what ultimately makes it so valuable. There are lots of cryptocurrencies that do exactly the same.

What gives bitcoin its value is that it is accepted as having value. People use it as a medium of exchange.

An increasing number of businesses use to to buy and sell goods and services,

more and more individuals use it to send and receive money.

It has value because people use it to convey value.

This is how money works. Civilisations down the ages have used any number of things as money. Gold and silver coins. Shells. Beads. Twelve-foot-high, four-ton discs of limestone (divisibility here coming a firm second to scarcity and resistance to counterfeiting). If it’s accepted as money, it’s money.

What confers value on bitcoin as a form of currency is the increasingly large network of bitcoin users. The increasingly large network of bitcoin miners ensures the protocol’s security (maintaining its scarcity and resistance to counterfeiting), but the miners don’t create value, they follow it.

The bottom line: bitcoin isn’t backed by energy. It’s backed by bitcoiners.

Brandon Hurst

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