In the shadow of the beast – will altcoins overthrow bitcoin?

Bitcoin retains a 38% market dominance and continues to drive the market – but will this change?

Black and white photo of a woman walking in shadows                                 
Altcoins have promised great things, but what exactly are they and can they deliver? Read more…
                                

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The emergence of bitcoin over a decade ago has spawned thousands of other cryptocurrencies, also called – because they are seen as ‘alternatives’ to the Daddy, bitcoin – alt coins. 

There is significant price correlation between bitcoin and altcoins – when bitcoin goes up, so do alt coins, and vice-versa – on top of continued market dominance by bitcoin, at 38% of all cryptocurrency by value.

Despite the endless assertions by new cryptos that they have improved on the original technology, it raises the question: will bitcoin continue to be the bellwether for the whole cryptocurrency market.

Scrutinising the interaction between bitcoin and its many rivals also brings several other important questions: how and why is bitcoin valued? Are altcoins valuable by proxy of the original, or do they have value in their own right? What is the network effect of bitcoin and how does it affect market dominance?

So where do we start? First let’s do a quick review of bitcoin.

Bitcoin review 

Bitcoin was developed in 2008 by the pseudonymous Satoshi Nakamoto, whose true identity has still not been confirmed. The blockchain technology enabled a system where transactions could be safely and securely made on the internet without the need of a third party or financial intermediary.

While the digital revolution created digital abundance , with the same information able to be shared with millions at a click of a button, Bitcoin was revolutionary in the fact it created the possibility of digital scarcity. Given the fact value is, in a large part, the difficulty of obtaining something, Bitcoin allowed value to be transferred across the internet.

Bitcoin’s finite number of coins, combined with a highly secure technological system founded on cryptography, created the possibility of a digital entity being a store of value. Bitcoin’s emergence also shed a light on the current system, in which fiat currencies have been debased by central governments and as a result caused, especially as of late, sometimes severe inflation problems.

Of course, while bitcoin as a currency is a prospect that has yet to materialise, and with its deflationary model, is currently inappropriate for widespread use as a currency, the ethos behind this at least superficially anarchic proposition has no doubt in part contributed to its network effect. What is a network effect? We’ll go into this in a minute.

Store of value 

While bitcoin is touted as being many things in the future, from the global currency to the new gold, bitcoin is first and foremost a store of value.

Hodlers, to use the cryptocurrency slang term for ‘holders’, from retail to increasingly institutional investors, have bought the currency to keep it in cold wallets and watch the ‘number go up’ – another popular crypto term used by would-be twitter crypto experts.

But when it comes to bitcoin, the number has largely gone up. In other words, the long-term price trend is positive. Despite being moments of extreme volatility, the coin has, year on year, appreciated in value. What is important here is that the price did not fall over long periods.

Furthermore, its deflationary design, while making it unsuitable for a currency, renders it a good store of value. This is because demand may well exceed supply, thus pushing up the price.

A constant or predictable supply is also often touted as desirable for a good store of value. Bitcoin has a supply schedule whereby one BTC is mined every 10 minutes, with a halving taking place every four years. Predictability and consistency help build trust, imbuing investors with trust in the technology and also in the coin.

As Dirk G. Baur of the University of Western Australia Business School and Thomas Dimpfl of the University of Tübingen School of Business and Economics argued in an article in the academic journal Empirical Economics last year, titled ‘The volatility of bitcoin and its role as a medium of exchange and a store of value’:  “Despite its high historical volatility compared to major currencies, bitcoin may evolve as a store of value and an alternative to other stores of value such as gold. Both the deflationary design and the decentralised and global nature enhance the store of value property and in turn make it unlikely that any country will adopt it as an official currency and thus lose control over the money supply and its monetary policy.”

With a market cap of $689bn, bitcoin, in a relatively short space of time has imbued investors with confidence that it is indeed a good store of value. As major institutional investors jump on the bandwagon in recent times, in the hope of finding yields and diversifying their portfolios, there is clearly trust in this supposedly trust-less system.

But how? And why?

Security of Bitcoin blockchain

Bitcoin is one of, if not the most secure blockchain, because of the number of nodes keeping track of transactions. With more than 10,000 nodes on the system verifying transactions, it is very difficult for bad apples to hack the system.

To wage a 51% attack on the system would cost $2.01m. In comparison to the $12,754 cost of attacking an altcoin such as Ravencoin, for example, Bitcoin's robustness in the face of bad actors becomes clear.

While other altcoins have improved the technology to process transactions more quickly, with lower fees and a streamlined system to make them more scalable, these coins have failed (at least for now) to gain market dominance. This is arguably down to three main reasons, the first being lack of network effect, the second a lack of differentiation within a highly saturated market, and third because of the scalability ‘trilemma’.

The scalability trilemma is the idea that in the process of making a blockchain more scalable, the decentralisation and/ or security of the blockchain is compromised.

Bitcoin, despite its flaws in terms of speed and high fees, is very secure and highly decentralised.

Unlike many emerging cryptos which use proof of stake as a means of consensus, bitcoin uses proof-of-work. There are numerous sources suggesting proof of stake is much more prone to greater centralisation and more vulnerable to hacks.

Furthermore, very often the real-world economics that underpin the proof-of-work consensus mechanisms is entirely overlooked. In normal economics the input cost of zero does not result in an output cost of greater than zero: 0 = 0.

While bitcoin's digital scarcity is often publicised, and is indeed one way of creating value,  the value that emerges as a result of the input costs, both environmental (unfortunately) and materially, is all too often forgotten. The cost of mining gold in terms of human life, resources and energy is inextricably tied with its high cost. As articulately put by Bob McElrath, a Washington, DC-based blockchain consultant: “Mining provides a value anchor for the cryptographic asset in terms of real-world expenditures”.

Grounded by the economic realities of Bitcoin, altcoins can develop new and (apparently) game-changing types of consensus mechanisms that use up minimal energy and require no investment; but without Bitcoin, the question is, would they float up into the clouds, no longer tied to any material constraints?

Network effect: crypto price correlations

Bitcoin, as the first and the most famous and the purest example of a peer-to-peer decentralized network, has gained a huge following and an enormous amount of exposure.

No longer the remit of anarchic fringe crypto techies, Bitcoin has become a household name.

The high adoption rate of Bitcoin, combined with its high level of exposure means it has a high ‘network effect’. This phenomenon occurs when new users joining a given network increase the value of the network for other users. The arrival of new users, in turn, makes it more attractive to other potential users.

Bitcoin relies on new users to get involved, to drive up prices and drive up confidence. The more people that see value in a system, the more its value increases.

So, what does this have to do with the interaction of Bitcoin and altcoins?

Function of altcoins

Altcoins have been developed for four main reasons: to improve or solve the perceived limitations of Bitcoin as a good means of exchange (high fees, costly environmental damage, and low transaction speeds); to imitate Bitcoin (take meme coins with no apparent utility for example);  to create more privacy (to do what Bitcoin does but enable greater privacy for users ;) and to replicate digital stores of value but in different forms (non-fungible tokens or metaverses).

Altcoins such as Futurepia, EOS and Ripple all have been developed as faster alternatives. Blockchains such as EOS and IOTA have developed cryptos with no transaction fees at all.

Looking at the first category (altcoins developed to solve bitcoin’s limitations), rather dismally, although billions have been invested into these coins, their current utility remains limited. Much of this investment has been done so with the idea that one day, when Web 3 replaces the current system, these companies will rise up and become the base architecture.

The problem is that having failed to solve the scalability issue, with a much smaller network effect, and potentially not much demand for their offerings, these smaller altcoins, despite supposedly possessing vitally important features, have not caught on.

Not ready for lift-off? 

According to Deloitte data, back in 2017, out of more than 86,000 blockchain projects, 92% had been shelved by the end of the year. Despite whole divisions being set up in large companies dedicated to developing blockchain products, the number of these projects that end up going live and becoming a workable product is minimal.

Data from Blockdata found that 81 of the top 100 public companies in the world as of September 2021 were engaged in blockchain. While 16 of these companies are in the research phase, 65 are in the development stage, of which 27 have live operations.

While some of the 27 are incorporating blockchain into the operations of the business, such as Honeywell using blockchain to digitise aircraft records, others, such as Paypal and Shopify simply accept crypto as payment.

While it may sound impressive that 81 of the world’s biggest companies are using blockchain solutions, discovering how many of these get past the development stage, and how many of the products significantly affect the operational running of the company, would be an interesting exercise. What is clear, is that throughout the years, countless large projects, from Nasdaq to the Dutch Central Bank, have been shelved.

Lack of demand

The problem, perhaps, lies with the lack of demand or need for a product. Sceptics often argue that crypto is a solution in search of a problem. If there is a great need for a product, its traction grows rapidly. Take bitcoin as a store of value, for example. With low interest rates meaning cheap money everywhere and overpriced traditional asset markets, the demand for investors to find new ways of hunting for yields is significant.

Similarly, retail investors, not versed in or suspicious of traditional financial markets, have found crypto fulfils a need. Altcoins have similarly been pumped full of investors’ money in the hope that the “number goes up” will prevail. This, in turn, combined with a number of other factors (including BTC as reserve currency and BTC as intermediary between fiat and altcoins in exchanges) has led to a high correlation between bitcoin and altcoin prices. 

If you are living in a country with a stable economy, there is no great need to stop using fiat currency in favour of crypto. Similarly, with many ways to make digital transactions across the internet, the requirement for a new replacement to this is currently limited.

This perhaps helps explain why, despite the potential of blockchain being touted for the past decade, real-life examples of blockchains currently in use are, while not non-existent, certainly limited, especially given the jaw-dropping amount of investment that has gone into them.

So, what does this have to do with the relationship between Bitcoin and altcoins?

There are two explanations for the reason why altcoins have amassed the traction they have, despite not being (or at least having proven themselves to be) as good a store of value as Bitcoin and not yet realizing their potential utility in the world.

Trust is a major component. Investor trust helps drive the network effect. Whether trust in altcoins has amassed by proxy through investors’ trust in bitcoin, or because investors truly believe these coins will have some significant future use in the world (as a result of overcoming the limitations of bitcoin) is a difficult question to answer: it may be a combination of both.

Generally, new technologies overthrow old technologies as a result of the new doing what the old do better or more efficiently. Old technology satisfies a demand, and the new technology satisfies the demand more effectively. The current major function of bitcoin is as a store of value. There is no other crypto that acts as a better store of value than bitcoin.

This was expressed articulately by Francesco Galati, writing in the online magazine Medium, in an article titled “Why most cryptocurrencies don’t have a reason to exist”. Galati said: “It is possible to argue that the main reason for the existence of altcoins was that Bitcoin’s functionalities are currently limited and that is seen as a weakness – a problem to be solved.

However, what most people underestimate is that Bitcoin was built like this because it was meant to be like this. Its script language is intentionally not Turing-complete, with no loops. This goes against the flexibility and number of operations that can be carried out but prioritises the security of the network”.

Bitcoin never met the demand for a new global payment system, in part perhaps because there is no such demand.

Final thoughts 

As Peter Drucker, an influential business philosopher and management consultant wrote: “There is nothing so useless as doing efficiently that which should not be done at all.”

For altcoins to rise and overthrow Bitcoin, they would have to identify an actual need and then meet it, rather than developing new technology in the hope of meeting some potential abstract future need. It is probably important to clarify that I am not suggesting that a handful of coins are not fostering or developing good ideas, such as tokenised data developed by the Oasis Network working towards a more responsible data economy. I am simply stating these good ideas are currently – well – just good ideas. Their value is based on either future use, or (in most cases) the ‘coin go up’ mentality. 

Until their day in the sun arrives, altcoins will have to content themselves living in the shadow of the beast. Investors, conflating opacity with value, may have to content themselves with the fact, shrouded in darkness, they don’t understand what the object of their investment is – and indeed why they are investing in it in the first place.

The influence of the bitcoin price on altcoins is strong. As the original coin, it has amassed by far the largest confidence among investors. It has a market dominance of 38%, meaning that when BTC experiences a shock, so usually do altcoins. If investors lose confidence in bitcoin, they, in turn, lose confidence in altcoins, thus leading to a high bitcoin and altcoin price correlation. Furthermore bitcoin is the reserve currency for exchanges and is often the currency which investors have to buy in order to then buy altcoins.  

The cryptocurrency correlation does not follow the same pattern for all coins. With some, there are higher crypto price correlations than with others. 

It has been found by some experts that there is a strong cryptocurrency price correlation over the short-term rather than the long-term. 

Further reading

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