Bitcoin: A Wealth Annihilation Scheme

Economic bubbles are destructive, because they pour human activity and natural resources into activities that end up in vain. As an example, the Canal Mania of the late 18th and early 19th century, left the British landscape littered with unfinished canals, built by bankrupt companies. In other cases, office buildings or houses are built that never end up used. In the case of the Bitcoin bubble, massive amounts of money and natural resources have been poured into a planned digital currency, that didn’t end up used as a currency.

The proponents of Bitcoin today argue that Bitcoin shouldn’t be used as a currency, but rather, should be used as a store of value. This makes no sense, as a store of value needs an underlying use case. Without a use case, there’s no reason to believe that someone will be around in the future to desire the object you purchased. When there is no use case whatsoever for an object, the value ultimately declines to zero. We are thus left with nothing more than a speculative bubble.

In the case of Bitcoin, there is overall no significant economic value created. There is money that enters the system and money that leaves the system, but there’s no reason to believe that some sort of use case exists that delivers a benefit to society. The money that can leave the scheme, can not exceed the money invested into the scheme. Because the supply of an individual cryptocurrency can not increase in response to a change in price, small investments can lead to an enormous market capitalization. According to JP Morgan, six billion dollar net inflow (the amount put in, minus the amount pulled out) in cryptocurrency, was sufficient to raise its market capitalization to three hundred billion.

Taking Bitcoin, with a market capitalization of about half that amount, we would estimate that net inflows at this point would amount to three billion dollar. However, due to the fact that many alternative coins are pre-mined and have gone through even more absurd bubbles than Bitcoin, this estimate it probably too low. We could be generous estimate instead that two thirds of money invested in cryptocurrency has been invested in Bitcoin.

In other words, this would mean four billion dollar more has been invested in Bitcoin than has been retrieved by those who have cashed out so far. There is one problem however: In contrast to a game of poker in a pub or other simple gambling schemes, the Bitcoin scheme also has a vast underlying economic infrastructure that ends up costing money. For this reason, gamblers can’t retrieve 100% of the money invested by other gamblers. Billions of dollars will go missing and end up serving to sustain the infrastructure that enables the speculative bubble. For this reason, Bitcoin is better characterized as a wealth destruction scheme than as a wealth redistribution scheme.

Where does all of this money end up? We can start off, by looking at the biggest and most important place where money seeps out of the scheme: Bitcoin mining. To keep the network “decentralized”, Bitcoin allows transactions to be validated by whoever manages to solve a complicated computer puzzle. The winner of the puzzle earns new Bitcoins. Because bitcoins are currently valued at around 8000 dollar per coin, bitcoin miners are willing to spend large amounts of money to win a new bitcoin. The costs these bitcoin miners incur, are one way in which money seeps out of the system. If your mining machine spent five dollar in electricity, to earn ten dollar in bitcoin, someone had to pay ten dollar for your bitcoins, but you only end up with five dollars yourself.

How much money seeps out of the system in this manner? The annualized electricity costs of Bitcoin currently amount to roughly three billion dollar. Of course, this is not the same as the amount of money that has seeped out of the system through bitcoin mining so far, as the amount of electricity devoted to mining was much lower back in 2017. As late as half a year ago, the system used an estimated 75% less electricity to sustain itself. A back of the envelope estimate would be that 750 million dollar has left the system in 2016, solely due to the electricity costs. We can round this up to 1 billion dollar.

However, the electricity costs of the mining industry are not the only manner in which Bitcoin seeps money. Consider the mining machines themselves. Someone needs to pay to build a Bitcoin mining machine. How much money does it cost to build a Bitcoin mining machine? Today, you can buy an antminer S7, with 4.73 Terahash per second worth of hashpower, for 490 dollar. This means 103 dollar gets you 1 TH. The system currently uses 28 million terahashes per second. So, using an antminer S7 as a baseline estimate for modern Bitcoin mining machines, we discover that all of the mining machines currently being used would cost around 2.884.000.000 dollar to purchase. In reality, some people are currently mining using outdated equipment, in a desperate effort to break even. In addition, people in the past purchased mining machines that have now been abandoned.

What happens to all of this money? Some of this money ends up serving as salaries, for engineers who could have spent their time doing more useful stuff, like building refrigerators that use less electricity or designing machines with longer life expectancies. Some of the money ends up serving as corporate profits. Some of the money however, ends up spent on the base materials needed to produce these machines. All of this money, represents wealth that has been misallocated. Like the British canals that were never finished, or the brand new Dutch offices that were never occupied and had to be demolished after the Great Recession, resources we misallocate are permanently lost in pointless endeavors.

So, a rough estimate that only takes the process of Bitcoin mining into consideration, would be that regular investors, assuming they have invested six billion dollar into Bitcoin, could expect to retrieve about 2.2 billion dollar, if the scheme came to an end today. In reality, Bitcoin doesn’t just require mining, it requires Bitcoin exchanges. Those exchanges have personnel, office buildings, computers, specialized storage devices that need to be paid. You’re paying for those costs, in the form of various transaction fees.

Of course, the reality remains that thieves end up stealing a share of the money invested by legitimate investors. In the world of cryptocurrency, theft is an ambiguous term, as practices that seem like fraud to one person, may seem legitimate to other people. As an example, many exchanges refuse to credit people who accidentally sent Tether to a Bitcoin address. In other cases, exchanges bet against their own customers, or profit off the fact that scammers use old people’s bank accounts to purchase cryptocurrency.

Some bitcoin exchanges refuse to send bitcoins to shady online merchants and instead keep those bitcoins for themselves. The inexperienced cryptocurrency user assumes the online merchant scammed them, not realizing the online merchant never received the bitcoins from the exchange to begin with. If the user ever bothers contacting the exchange, the exchange will generally offer the user his money back, as the bitcoin has increased dramatically in value. The exchange pockets the difference, but the user generally has no clue. In the rare event where the bitcoin has decreased in value, the exchange simply refuses to refund the user the whole amount. The exchange will certainly not offer the various Bitcoin forks that emerged in the meantime. In any other industry this would be considered a scam, in the world of cryptocurrency this is a profitable endeavor.

These are some of the hidden in plain sight scams exchanges engage in. However, there are also various clandestine scammers out there, anonymous hackers who decide to scam the exchanges instead. One estimate is that 14% of all Bitcoins and Ether have simply been stolen. If we assume that six billion dollar has been invested in Bitcoin, one billion dollar spent on electricity and 2.2 billion dollar spent on mining machines, then of the six billion dollar that can flow out of Bitcoin again, 392 million dollar would be expected to end up in the hands of hackers who eventually cash out their bitcoins. In this case, I assume hackers are as likely as other Bitcoin users to cash out their balance. We’re now left with a very rough estimate of 3.6 billion dollar that can’t be cashed out of the system by its legitimate users and 2.4 billion that’s left for the legitimate speculators to recover from the scheme, assuming no more money would be inserted into the scheme.

So, assuming 3.6 billion dollar was lost to scammers and to maintain the underlying infrastructure, we can compared the amount of money lost, to the amount of legitimate commercial activity the system has enabled. Bitpay claimed to be on track to process one billion dollar worth of transactions in 2017. I doubt they processed more than 1 billion in 2017, as transaction fees began to explode in the months after their statement. We’ll be generous and assume they genuinely processed one billion dollar worth of legitimate transactions. An estimate from 2015 claimed that 60% of Bitcoin merchants use Bitpay. So, we can estimate that the Bitcoin market as a whole processed 2 billion dollar worth of transactions in 2017, assuming Bitpay kept most of its market share.

Let’s make a quick comparison to regular financial instutitions. In 2016, Mastercard had expenses that amounted to 5 billion dollar. Mastercard had a purchase volume in 2016, equivalent to 1,165 billion dollar. That’s a ratio of 1:233. Bitcoin in comparison, seems to be looking at a ratio closer to 1:1, if we only look at relatively legitimate transactions. Bitcoin’s ratio however is merely going to get worse as the scheme continues, due to the rapid increase we’ve seen in expenses made to mine new bitcoins, while merchant acceptance is in decline. Ironically perhaps, Mastercard currently has a market capitalization of 183 billion dollar. Bitcoin has a market capitalization of 140 billion dollar. Could it be, that Bitcoin is currently overvalued?

Based on these figures, we arrive at the conclusion that Bitcoin has wasted roughly as much money by handing over money to criminals and mining new bitcoins, as it has enabled economic transactions so far. For a payment system this is ridiculous of course, but it’s nonetheless the sad reality we find ourselves faced with. Imagine visiting the supermarket today, paying fifteen dollar to buy your groceries and realizing that 10 dollar were spent to processes your payment, while another five dollar were stolen from your bank account. That’s effectively how Bitcoin currently works. We can nitpick over the details of my estimate, but my calculations are not going to be off by an order of magnitude.

This leaves Bitcoin investors with an unfortunate realization. Bitcoin, is a wealth destruction scheme. Bitcoin doesn’t create value and investors can’t pull anywhere near as much money out of the scheme as they invested into it. Those who have pulled more money out of the scheme than they invested into it, are thereby profiting off those who step in at a later point in time, who will be unable to replicate their success. Plenty of speculators will see big dollar figures in virtual wealth on their account, but those who end up with a genuine profit, in the form of actual money on their bank account, will always be a small minority of Bitcoin speculators.

 

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