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Programmable Money & DeFi: A Hedge Against Inflation

Bitcoin (BTC) has been expanding over the last years as a hedge against inflation. This is not only true when we analyze the expansion of BTC price but we can see it in the way Bitcoin works and how it has been programmed.

In order to understand Bitcoin and how it works as a hedge against inflation, we need to compare it with legacy systems.  Although we usually tend to think about inflation in countries such as Venezuela or Argentina, inflation is also a silent killer in most countries around the world.  Strong FIAT currencies have seen inflation rates increase drastically recently due to quantitative easing policies amidst the additional efforts required to  fight back COVID-19.

Increasing interest rates is always an option to reduce inflation but history has repeated itself many times and many people around the world are just looking to diversify their risk as much as possible. That’s where Bitcoin comes into the equation.

In this guide, we will analyze how Bitcoin is becoming a predominant option to fight inflation even in the context of high volatility and irrational markets behaviour. Let’s begin!

 

FIAT Money: The Current Landscape After the COVID Crisis

FIAT supply has been rapidly growing over the last years, specifically after the Coronavirus (COVID-19) pandemic that hit the world in 2020 and 2021.  People around the world were deprived of doing many things, including work. Some companies were obligated to shut their operations down for several weeks, generating a devastating economic impact on households and firms. Some other lucky companies were able to move to remote working. 

Without being able to work, individuals were not able to receive salaries. This  created a shock in monetary terms and in order to fight against this problem large amounts of money were printed.

As an example, the Coronavirus Aid, Relief and Economic Security Act (CARES Act) delivered a $2.2 trillion economic stimulus. These types of measures were taken by developed and emerging economies generating a massive acceleration on monetary expansion. Along the process, many economists warned about the undesired effects that such policies could generate in terms of inflation. In Milton Friedman’s own words, inflation is nothing else but taxation without representation. Monetary expansion is indeed encouraged to prevent an economic depression but not without a well-thought plan to mitigate the currency debasement process that’s triggered by money printing.

Though central banks have a wide set of options to control inflation, COVID monetary relief programs have activated many alarms. Increasing interest rates and money scarcity can help stabilize prices but the long term picture is quite clear. Inflation is here to stay. 

Inflation: Taxation Without Representation

As we have seen in the previous section, inflation has been growing in the last few months at an accelerated rate after the economic measures taken by governments to fight the negative effects of lockdowns and the spread of the Coronavirus. 

Inflation could be considered as a tax because it is the price for holding cash. In other words, your savings are taxed with the rate of inflation. With growing inflation rates, your money becomes less valuable because its purchasing power diminishes.  

Governments that decide to print money are not searching consensus with other political parties. They are simply printing the FIAT currency they need. Inflation will many times do the dirty work. Rather than paying the political price of increasing tax rates, governments will many times just prefer to print more money.

 

Bitcoin Economic Fundamentals

Bitcoin (BTC) is different. It works in a completely different way compared to how governments handle the money supply. Bitcoin is a cryptocurrency that has no centralized authority and that was created to reduce the influence of central bankers and traditional financial institutions in the financial world. There will only be 21 million bitcoins. No fiat currency has a limited supply.

Bitcoin  works as an open ledger where all the transactions are verified, registered and tracked. Everyone is able to make sure that Bitcoin transactions are properly processed and they are not spent twice. Due to the limited supply of 21 million BTC, Bitcoin acts as digital gold. 

 

Bitcoin Minting & The Halving Process: How are Bitcoins created?

Bitcoin is programmable money for different reasons. One of them is related to the way in which new bitcoins are created. As previously mentioned, Bitcoin has a limited supply of 21 million. Bitcoin’s inflation rate is controlled by the algorithm difficulty. Currently, 6.25 BTC are minted per block and each block is created in average after 10 minutes. The algorithm difficulty is adjusted based on the hashing power of the network to prevent block creation acceleration. 

Additionally, BTC block reward diminishes on time with the next halving expected to take place on May 14, 2024. This will reduce the block reward to 3.125 making BTC more scarce and creating upward pressure on the price. DCA and S2F are quite clear: You just have to hold.

Algorithm Difficulty & Hashing Power: Controlling the Minting Rate

In order for Bitcoin blocks to be processed every ten minutes (or close to ten minutes), there is a natural adjustment on the Bitcoin network going on 24-7-365. Bitcoin works with a Proof of Work (POW) consensus algorithm and miners provide the hashing power to the network. 

The aggregate Bitcoin hash rate is equal to the hash rate of each of the miners on the network. The larger the hash rate, the more difficult it becomes for a single miner to receive rewards. 

Let’s now suppose that the Bitcoin hash rate doubles overnight. What will happen is that for some time, blocks might be processed at a faster rate (thus, increasing the number of new BTC minted per day).  This will last until the next difficulty adjustment is triggered. In this way, the minting rate remains stable and does not increase on average in the long run. On the contrary, reduced hashing power means that miners are usually incentivized to enter the network as getting block rewards is less complicated.

 

The Scalability Challenge: Fees & Network Congestion

Bitcoin has faced many challenges over the last years and one of them is related to scalability. This is probably the biggest issue when it comes to Bitcoin. Bitcoin is able to process between 5 and 7 transactions per second, far from the thousands of transactions per second that traditional payment processors can handle.

During periods of network congestion, the number of BTC transactions increase exponentially generating bottle-necks and prohibitive network fees. In order to solve the scalability problem, developers have been working on second-layer scaling solutions for a very long time including the Lightning Network (LN) and RSK’s Unitrie.

 

The Interoperability Challenge: A Symphony of Blockchains

Though scalability is probably the most important challenge that Bitcoin needs to overcome, interoperability is definitely another quite important variable. In a context of growing smart contract platforms with several use cases, protocols and algorithms, efficient and affordable communication between different blockchains is a must-to.

On this regard, RSK brings smart contracts to the Bitcoin community with an ecosystem that is easily interoperable with Bitcoin and other blockchain networks thanks to the token bridge. In simple words, RSK makes it possible for users not only to develop smart contracts on top of Bitcoin’s network but also to directly interact with other blockchains and their protocols.

ETFs & Institutional Investors: What´s Next for Bitcoin?

If we think of Bitcoin as the evolution of the financial world, we cannot exclude corporations from our analysis. Corporations are purchasing Bitcoin and integrating it into their balance sheets. ETFs would simply set Bitcoin as a new asset class which usually speeds up the adoption process both for corporate and retail investors. Although several Bitcoin ETFs proposals have been rejected, it looks like it’s just a matter of time just like it happened with gold ETFs.

Overcoming Regulation FUD: How Could Regulation Help the Crypto Markets?

One of the things that has affected Bitcoin over the last years is the FUD from governments and regulators in different jurisdictions. Regulations will eventually be a reality in most countries. Until now, there is no standard worldwide procedure on how to regulate Bitcoin and the whole crypto market. Policy-makers will have to find a way to regulate Bitcoin without a doubt. 

Regulations could also be positive for Bitcoin and for companies that want to operate with the largest cryptocurrency in the world. Nowadays, some banks and institutions are not able to offer solutions to crypto projects or investors that want to get access to the crypto market due to the lack of a clear regulatory frameworks.  Corporations and traditional banks are also searching for these legal frameworks not only to attract new investors but also to offer new and more sophisticated financial services & products.

At the end of the day, end users just want options to mitigate the risks of inflation. In a context where crypto is becoming the standard for many and DeFi keeps providing considerably higher APYs against legacy options, the future looks quite bright for blockchain tech and Bitcoin if you have the long term mindset.