Thread by @paraschopra

1/ Bitcoin price is falling off the cliff. It was $20k at peak and now in 30 days, it has crashed 64% to around $6k today.

What’s happening? The answer lies in its network effects.

This thread will explain how bitcoin rose and why it’s falling.

2/ Here's bitcoin without network effects.

In early days of bitcoin, few enthusiasts who believed in developing a system where anyone could send anyone else money without a central authority (like a bank) or without requiring anyone’s permission (like a government).

3/ Early bitcoin enthusiasts invested their hard earned money and time in setting up this network. Let’s assume that the cost of doing this was $X and the network had a total of BTC A amongst all of them.

4/ They couldn’t spend BTC for pizzas yet but if someone had come to purchase BTC from them, you’d expect them to at least want to recover their investment by offering X/A exchange rate (for USD/BTC) for offsetting their investment in electricity, storage, bandwidth.

5/ This value would have been theoretical had it not been for someone actually paying USD for bitcoin.

So, why does anyone pay USD (or other govt backed currencies) for bitcoin?

6/ This is because bitcoin solves an actual real-world need of cross-border, permissionless transactions.

For example, if you want to buy a banned book from abroad, your option is either do Hawala/money laundering or buy bitcoins from someone and use it to pay the online shop

7/ This demand for bitcoin for actual use is one legit reason for people paying USD for bitcoins. Part of bitcoin’s price is grounded in real-world use

When people demand bitcoins from miners, the demand caused bitcoin's price to go up. This is basic demand-supply from Econ 101

8/ Why does the bookseller accept bitcoins? Because proof of work part of bitcoin protocol gives them confidence that Rose would have necessarily spent minimum $100 worth of money to generate this amount of bitcoins.

9/ You cannot generate bitcoins WITHOUT spending money in running computers, paying for electricity, bandwidth or storage.

If bitcoin were database entries, anybody could make new bitcoins with one single SQL query (that’s what governments do when they “print” new money)

10/ The key point to understand about bitcoin’s price is that: If you’ve invested or purchased something for money, you’d hate to see its value go to zero.

11/ For bitcoin network to work, miners or bitcoin enthusiasts are required to spend real economic value (in terms of computation power for proof of work). 

This avoidance of loss gives us a lower limit for bitcoin’s price. It’s not zero.

12/ With more people having bitcoin, the utility of being able to accept and receive bitcoin increases exponentially. See Metcalfe’s law that states that the value of a network is proportional to the square of the number of connected users of the system.

13/ Here are multiple feedback loops that drive up bitcoin’s price. Notice that same feedback loops can also cause prices to come down.

14/ The volatility in market is caused by the arrival of speculators and traders in the market who do not care about the intrinsic value of bitcoin but completely base their decisions on market trends and emotions.

15/ Bitcoin right now could be compared to pre-2000 Internet bubble where anyone and everyone had invested in an Internet stock. With the 1999 crash, many speculators lost money. However, Internet kept on booming even after 2000 crash

16/ As @AswathDamodaran says, there’s a difference between pricing or valuing something. If you believe bitcoin solves a real-world need, it’s going to be valuable in the long run. In the short run, however, the price can go anywhere.

17/ This thread is an excerpt from my new article: Bitcoin is mother of all network effects invertedpassion.com/bitcoin-is-mot…

Thanks @nileshgr, @pranay01, @robytj and @sia_steel for early review.