Bitcoin’s original vision laid out in Satoshi Nakamoto’s whitepaper was to be a medium of exchange. The 2009 whitepaper, Bitcoin: A Peer-to-Peer Electronic Cash System,1 focused exclusively on its usage as a currency, and most of Satoshi’s other public statements supported this.2 In its early days, when bitcoin was new and illiquid, it would have been nearly impossible to find a transacting partner to purchase goods or services.
The first known bitcoin price was established on October 5, 2009, by exchange New Liberty Standard, with $1 equaling roughly 1300 BTC.3 The price was determined based on estimating the costs to mine bitcoin. An established fiat exchange rate could then attract speculators and investors, growing demand and liquidity. Since then, bitcoin has served as money in some circles – notably as payment on the infamous Silk Road marketplace and more recently as legal tender in El Salvador – but it has primarily been used for investing. Its biggest advocates have pushed the bitcoin narrative from its initial design of a payment system to a store of value and, in parallel, an inflation hedge or “digital gold”.
In the wake of bitcoin’s recent decline in price against the backdrop of poor economic data, we wanted to explore its potential as a store of value and revisit its standing as a medium of exchange. Specifically, this paper compares bitcoin to a historical store of value, reviews bitcoin’s recent performance and volatility, and explores its growth trends as a form of currency.
A Historical Benchmark
A store of value is typically defined as an asset that holds its purchasing power into the future. An inflation hedge is one possible characteristic of a store of value in that the asset tends to retain or increase its value relative to some other depreciating asset (i.e., fiat currency). Past performance indicates gold can be a useful benchmark for both a store of value and an inflation hedge. Of course, other asset classes have achieved returns many times higher than gold over time but are likely not considered stores of value.
Qualities of a store of value, of which money is deemed, include scarcity, durability, portability, and divisibility.4 Bitcoin (BTC) certainly satisfies these qualities and simplifies their practical functions. Other comparisons to money, especially gold, are more abstract. For example, bitcoin has a 12-year history versus 6000 for gold. Ancient civilizations used gold as a store of value, a medium of exchange, and a thing of beauty. Some even worshipped gold, believing it to represent gods and immortals.5 Beyond the historical and cultural significance, BTC is intangible, and its scarcity is digitally enforced rather than physically. Its price has appreciated over 100,000% (according to Sherlock’s earliest BTC price, August 2011, to August 2022) vs gold’s 23% over the same period. Both are valuable but for different reasons.
Bitcoin may be better characterized as an emerging store of value – meaning that its price may fluctuate but grow purchasing power over time until it eventually stabilizes. Valuing BTC today, however, is difficult. One method is to extrapolate its price history on projected adoption trends. This approach originated from a 2018 paper by Timothy Peterson and applies a similar methodology as Metcalfe’s Law, which uses network effects to estimate value. Fidelity Digital Assets modeled bitcoin’s value using this methodology in a June 2022 research paper titled Valuing Bitcoin 6. Bitcoin adoption trends have been steadily rising. The number of unique wallet addresses holding at least 0.01 BTC has nearly doubled since 2018.7 Demographic shifts are also favorable to bitcoin and crypto more broadly, with younger investors being more accepting of digital assets and often dismayed by traditional banking and financial systems.8
Increasing Correlation to Risk Assets
The recent economic shocks stemming from COVID-19 – inflation, interest rate hikes, and supply chain bottlenecks – and Russia’s invasion of Ukraine have caused a selloff of risk assets. Bitcoin has been a victim of the selloff. Figure 1 shows the steady increase in bitcoin’s correlation to the S&P 500 since the economic impacts of pandemic response measures landed towards the end of 2021. The 90-day correlation coefficient of 0.44 (as of August 31st) is trending near all-time highs.
Looking back further, the onset of the COVID-19 pandemic in March 2020 sent BTC tumbling 43% in less than a week. Similarly, the S&P 500 dropped 15% over the same period (and further extended its losses for several days thereafter). In the US, a favorable monetary policy response resulted in money flowing back into risk assets. Figure 2 shows that bitcoin’s price, by contrast, recovered and stabilized for several months resulting in negative correlation to the S&P 500 (Figure 1). BTC ultimately reached a new all-time high of $69.9k in November 2021 before dropping to its current value of roughly $21k today. The decline coincided with higher-than-expected inflation data and interest rate hikes.
Putting the “Currency” in Crypto
Bitcoin was initially designed to serve as a currency – one that is incorruptible by governments and individuals. However, the Bitcoin network is too slow and expensive to serve as a global, high-traffic payment mechanism for everyday purchases. Network fees averaged $1.14 per transaction during the month of August as Figure 3 shows. Miners also are incentivized to validate transactions with higher fees, which can introduce inequality. Bitcoin can process approximately 7 transactions per second (TPS). By comparison, newer blockchains with simpler consensus mechanisms routinely process thousands of TPS and are actively developing scaling solutions to increase throughput.
A scalable, low-fee payment solution for Bitcoin is the Lightning Network (LN), an off-chain “Layer 2” payment system where transactions are sent over a network of micropayment channels.9 Although Bitcoin did not develop the LN and it could operate on other blockchains, Bitcoin is the network of choice, likely due to its dominance and currency-focused design. The LN is designed to be highly scalable (theoretically supporting millions of TPS) and extremely low cost (fractions of a penny). In just three years, the LN has seen significant growth. Because of its design, obtaining network-wide data like transaction count is nearly impossible (this would require access to data from every node on the network). Instead, we can use publicly available metrics like nodes, channels, and BTC capacity as proxies for its user-level adoption trends.
Figure 4 displays these trends since it launched in January 2018. The number of channels and nodes on the LN more than doubled in 2021, and the amount of BTC on the network tripled. Growth of nodes and channels in 2022 have plateaued, but BTC capacity on the network has continued to rise. There has also been positive news about LN expansion. Notable recent events include the LN becoming available on the Cash App and Strike integrating with Shopify to support bitcoin payments.
Arcane Research and OpenNode, one of the LN’s highest capacity nodes, collaborated on a report titled The State of Lightning: Volume 2 to further examine the LN’s usage.11 Using actual transaction data routed through OpenNode and other participating nodes, the report estimates the number of transactions and payment volumes on the LN. According to the report the number of payments doubled year-over-year from Februrary 2021 to February 2022; the value of payments increased by more than 400%.
The LN enables faster, cheaper, and near instantaneous settlement relative to leading payment system alternatives that link to users’ bank accounts. Its smart contract functionality could also open new possibilities such as decentralized finance applications and payment scheduling.12
El Salvadoran Case Study
In September 2021, El Salvador adopted bitcoin as legal tender. The government also bankrolled a bitcoin wallet app called Chivo to be used for transactions. Chivo is compatible with the Bitcoin base layer and Lightning wallets; it is integrated with the country’s banking system; and users do not incur transaction fees. Citizens who downloaded the app received $30USD in BTC to bootstrap its adoption.
An April 2022 study by the National Bureau for Economic Research (NBER)13 found that 20% of users who downloaded Chivo continued to use it after spending the initial $30. A Separate study by El Salvador’s Chamber of Commerce found that only 14% of the country’s businesses made bitcoin transactions since September 2021, and only 2% of remittances were sent with bitcoin.14
Prior to Chivo and El Salvador’s adoption of bitcoin, the NBER study notes that “over half of respondents used only cash to pay for their expenditures. We also find that more than 70% of them were unbanked and almost 90% did not use mobile banking. Moreover, we find that 64.6% of Salvadoreans had access to a mobile phone with internet, a technology required to download and use Chivo.”
The Wild West
Crypto can sometimes feel like the wild west. Recently the broader crypto market has suffered a series of unfortunate events specific to a handful of organizations with widespread ripple effects. On May 9th, one of the largest crypto ecosystems, Terra, collapsed due to an apparent attack on its algorithmic stablecoin, UST (see Glossary of Terms for more detail). This led to a massive selloff of LUNA (UST’s arbitrage-driven stabilizer) and a bank run on one of Terra’s native applications, Anchor Protocol.15 Several firms were exposed to Terra’s collapse and overleveraged in other positions.16 Many have since declared bankruptcy. In short, the entire crypto market has struggled with the fallout thanks in large part to poor risk management.
BTC is also highly volatile. A time series analysis of daily price action by Baur and Dimpfl (2020)17 found that bitcoin’s volatility between 2014 and 2020 has not declined by any statistically significant amount. Sherlock’s own volatility metric, calculated as the standard deviation of annualized daily log returns, shown in Figure 5, confirms that Bitcoin’s volatility has not declined during the same period. It’s unclear if or how volatility impacts its usage as a medium of exchange. Prices of goods and services are typically based in fiat currency, not BTC. Therefore, transacting parties run the risk of losses given the volatility of BTC/fiat currency exchange rate.
Based on BTC’s selloff and correlation to risk assets since the onset of inflation and other macroeconomic conditions, we infer that bitcoin is not an inflation hedge. Its standing as a store of value is more complicated given volatility, but bitcoin has certainly maintained and increased its value given a multiyear time horizon. Similarly, bitcoin’s standing as a medium of exchange is uncertain. The LN provides the platform necessary to support cheap, fast transactions and its adoption is rising. Conversely, El Salvador’s attempt to promote bitcoin as a payment system has been a failure thus far.
In its short history bitcoin has adopted several narratives, including those covered in this paper. It has been labeled worthless by some and touted as the future global reserve currency by others. Any conclusions about a nascent, disruptive, largely unregulated asset are bound to change.
What haven’t changed, however, are the core features that underpinned a $1.2T market cap at its peak: decentralized authority, programmed scarcity, and a proof-of-work consensus mechanism and incentive structure. Bitcoin has the qualities to serve as money and may one day prove a robust store of value. Given time, bitcoin may just create its own narrative.
The information herein was prepared by Sherlock Analytics. It is for informational purposes only and is not intended to constitute a recommendation, investment, tax, accounting or legal advice of any kind, or an offer or the solicitation of an offer to buy or sell securities or other assets. Please perform your own research and consult a qualified advisor to see if digital assets are an appropriate investment option.
This information is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. Persons accessing this information are required to inform themselves about and observe such restrictions.
Digital assets are speculative and highly volatile, can become illiquid at any time, and are for investors with a high-risk tolerance. Investors in digital assets could lose the entire value of their investment.
Some of this information is forward-looking and is subject to change. Past performance is no guarantee of future results. Investment results cannot be predicted or projected.
Sherlock, the Sherlock Logo are service marks of FMR LLC. © 2021 FMR LLC. All rights reserved.
Glossary of Terms
Pearson Correlation Coefficient: a measure of linear correlation between two independent sets of data, bounded between -1 and +1. Values closer to -1 suggest an inverse linear relationship between two sets of data (i.e. as A increases B decreases). Conversely, values closer to +1 suggest a positive linear relationship (i.e. as A increases B increases). Values near 0 indicate no linear relationship exists.
Layer 2 (L2): secondary protocols built on top of an existing blockchain, like Ethereum.18
Crypto ecosystem: refers to the tokens and decentralized applications (dApps; programs enabling user interaction with the blockchain) operating on a particular blockchain.
Stablecoin: digital assets designed to be pegged to fiat currency, most commonly the US Dollar. Some stablecoins are backed by cash, treasury reserves, and other assets. Others are crypto-native and backed by collateralized debt positions or function algorithmically.
Decentralized applications (dApps): blockchain-based applications that enable users to interact with smart contracts deployed on the blockchain.19
Smart contracts: a program, consisting of a collection of functions, that is deployed on a blockchain.20 A smart contract blockchain is one that supports deployment of smart contracts. Ethereum was the first smart contract platform, enabling it to run flexible applications. By comparison, Bitcoin is not a smart contract platform.
1 Satoshi Nakamoti. “Bitcoin: A Peer-to-Peer Electronic Cash System.” October 2008.https://bitcoin.org/bitcoin.pdf
2 Sam Patt. “Breakdown of all Satoshi’s Writings Proves bitcoin not Built Primarily as Store of Value.” June 2019. http://sampatt.com/blog/2019/06/06/breakdown-of-all-satoshi-writings-proves-bitcoin-not-built-primarily-as-store-of-value#objections
3 Bruno Marques. “New Liberty Standard Twelve Years Ago, Sold 1300 Bitcoins for 1 Dollar.” October 2021. https://www.cryptodefinance.com/1300btc-worth-1dollar-new-liberty-standard/
4 Federal Reserve Bank of St. Louis. “Functions of Money - The Economic Lowdown Podcast Series.” https://www.stlouisfed.org/education/economic-lowdown-podcast-series/episode-9-functions-of-money#:~:text=There%20have%20been%20many%20forms,%2C%20limited%20supply%2C%20and%20acceptability
5 Emily C. Floyd. “Tears of the Sun: The Naturalistic and Anthropomorphic in Inca Metalwork.” 2016. https://mavcor.yale.edu/conversations/medium-studies/tears-sun-naturalistic-and-anthropomorphic-inca-metalwork
6 Jack Neureuter. “Valuing Bitcoin.” May 2022. https://www.fidelitydigitalassets.com/research-and-insights/bitcoin-supply-demand
7 Jamie Redman. “Number of Addresses Holding BTC Taps 40 Million, Non-Zero Bitcoin Address Metric Grew 92% Since 2018.” May 2022. https://news.bitcoin.com/number-of-addresses-holding-btc-taps-40-million-non-zero-bitcoin-address-metric-grew-92-since-2018/
8 Coldwell Banker. “A Look at Wealth 2019: Millennial Millionaires.” October 2019. https://blog.coldwellbankerluxury.com/a-look-at-wealth-millennial-millionaires/
9 Joseph Poon, Thaddeus Dryja. “The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments.” January 2016. https://lightning.network/lightning-network-paper.pdf
10 Bitcoin Visuals. Data collected from Nodes, Channels, and Network Capacity charts. Last accessed August 18, 2022. https://bitcoinvisuals.com/lightning
11 Arcane Research and OpenNode. “The State of Lightning: Volume 2”. April 2022
12 Chris Kuiper, Jack Neureuter. “Research Round-Up: May 2022”. May 2022. https://www.fidelitydigitalassets.com/research-and-insights/research-round-may-2022
13 Fernando E. Alvarez, David Argente, Diana Van Patten. “Are Cryptocurrencies Currencies? Bitcoin as Legal Tender in El Salvador.” April 2022. https://www.nber.org/papers/w29968
15 Krisztian Sandor, Ekin Genç. “The Fall of Terra: A Timeline of the Meteoric Rise and Crash of UST and LUNA.” June 2022. https://www.coindesk.com/learn/the-fall-of-terra-a-timeline-of-the-meteoric-rise-and-crash-of-ust-and-luna/
16 Yogita Khatri. “Three Arrows Capital liquidation ordered by court in British Virgin Islands: source.” June 2022. https://www.theblock.co/post/154809/three-arrows-capital-liquidation-teneo
17 Dirk G. Baur, Thomas Dimpfl. “The volatility of Bitcoin and its role as a medium of exchange and a store of value.” March 2018. https://www.ncbi.nlm.nih.gov/pmc/articles/PMC7783506/pdf/181_2020_Article_1990.pdf
18 Ethereum. “Layer 2: Ethereum for Everyone”. https://ethereum.org/en/layer-2/
19 CSIRO. ”Decentralized Applications (DApps)”. https://research.csiro.au/blockchainpatterns/general-patterns/deployment-patterns/dapp/
20 Etherum.org. “Introduction to Smart Contracts”. https://ethereum.org/en/developers/docs/smart-contracts/