What Fraction of Bitcoin Value is Driven by Speculators?

At Quora, I occasionally play, “Ask the expert”. Several hundred of my Quora answers are linked at top right on this page. Today, I was asked “How much of Bitcoin’s value is driven by speculation”. This is my answer…

This is a great question! While the value of any commodity is determined by supply and demand, speculation is one component of demand. Another is the unique utility value inherent in a product or process. This is sometimes called ‘intrinsic value’.

It’s ironic that when a high fraction of value is driven by speculation, short-term value becomes volatile and long-term value becomes less certain—and less likely to produce returns for those same speculators.

Editor’s Note: In the past few weeks, a significant spike in Bitcoin’s value and trading volume relates to a pending regulatory decision expected at the end of next week. This activity is certainly driven by speculation. But for this article, I am considering periods in which the demands of individual events are less clear.

The value of Bitcoin is influenced by:

  • Day traders who buy and churn
  • Long-term speculators who buy and hold. This includes me.
  • Criminals who hope that cryptocurrency transactions can be more easily hidden than government backed currencies
  • Early adopters who use Bitcoin as a payment instrument or to send money
  • Vendors who accept the coin in exchange for products and services
  • Vendors who retain a fraction of revenue in Bitcoin (rather than exchanging to Fiat). To avoid a round trip, they seek to purchase materials, pay staff or settle debts with the Bitcoin they earned.

Here’s the rub: Bitcoin will not become a store of value unto itself (i.e. a currency), and it will not gain a significant fraction of the payment instrument market until the transaction volume of the first to user categories in the above list are overtaken by the the ones further down. Likewise, Bitcoin will not enter its biggest growth spurt until the last two items swamps the others as the largest motive for acceptance and use.

Put another way: Long term value must ultimately be driven by organic adoption from actual users (people who buy and spend Bitcoin on other things).

In another article, I expand on the sequence of events that must take place before Bitcoin grows into its potential. But make no mistake. These things will happen. In tribute to the brilliance of Satoshi, the dominoes are already falling.

In response to the question, I estimate that at the beginning of 2017, 85% of Bitcoin value is still driven by speculators. I have not analyzed wallet holding periods compared against the addresses of known vendors. Furthermore, it would be difficult to understand the relationship between the number of speculative transactions and the overall effect on value. Therefore, my figure is more of a WAG than an calculated estimate. But it’s an educated WAG.

The fraction of speculative transactions will drop significantly in the coming months—even as late speculators jump on board. That’s because uptake from consumers and businesses is already taking off. The series of reactions that lead toward ubiquitous, utilitarian applications has begun. Bitcoin’s value will ultimately be driven by use as a payment instrument and in commerce.

Because it is a pure supply-demand instrument, Bitcoin will eventually be recognized as currency itself. That is, it needn’t be backed by precious metal, pegged convertibility or a redemption promise. When that happens, you will no longer ask about Bitcoin’s value. That would be a circular question, since its value will be intrinsic. Instead, you will wonder about the value of the US dollar, the Euro and the Yen.

As a growing fraction of groceries, gasoline and computers that you buy are quoted in BTC, you will begin to think of it as a rock, rather than a moving target. One day in the future, there will be a sudden spike or drop in the exchange rate with your national currency. At that time, you won’t ask “What happened to Bitcoin today? Why did it rise in value by 5% this morning?” Instead, you will wonder “What happened to the US dollar today? Why did it drop in value by 5%?

Calculate Bitcoin Value: Modest assumptions

An experienced investor recognizes a speculative instrument or commodity. Depending upon your frame of mind and your opinion about its future, Bitcoin is either a payment instrument or a commodity. But either way, its supply is capped (not by edict, but by an indisputable mathematical formula), and so its value is a product of simple supply and demand economics.

Value: What assumptions are reasonable?

Value: What assumptions are reasonable?

I would never claim the foresight to predict the value of a bitcoin five minutes from now, let alone five years from now. Yet, I am baffled by its dollar exchange value today ($450 as I write this Wild Duck article). A reasonable and conservative calculation suggests that it should be—not $1200, as it was in late November 2013—but rather 100 times its current value.

Let’s consider one way to approach a calculation of the exchange rate necessary to support a low ball likelihood of its future utility…

Conservative Assumptions

  • Let’s say that Bitcoin never achieves the status of a currency—and that eventually, the expectation of enthusiasts that it will become its own “value store” turns out to be wishful thinking. Let’s assume that exchange rate mania was no more than the Dutch tulip-mania.
  • As a result, let us further assume that all speculative “investment” ends. Let’s just say that in 5 years, no one is interested in holding on to a bitcoin based on the expectation that its value will rise.

But, clearly, Bitcoin is very cost effective when used simply to transmit money for a purchase, loan, gift, or exchange. Even if both parties expect to convert back to regional currency after a short time, it reduces cost and leads to increased retained revenue.

Furthermore, it’s cost effectiveness is maximized as users retain their receipts in Bitcoin pending their own purchase of goods and services. In this way, they avoid any cost associated with a round trip exchange.

  • So let’s assume that consumers and businesses eventually hold 10% of their receipts in Bitcoin longer than a day. In this way, a certain amount of “coins” are required just to cover circulation.

Now, for more of our facts & assumptions…

  • Today, 85% of transactions are US dollar denominated.
  • Each day, the world needs about $3 trillion dollars to float current transactions. Additionally, the currency markets require another 3.98 trillion dollars for banks, exchanges, escrows, reserves and other activities driven by currency “markets”.
  • Let’s further assume that these 2010 figures never grow. Despite China’s massive growth and significant recover in the west after the 2010 recession, we will effectively freeze the world economy at 2010 levels.

There is no reliable data on the turnover rate of purchase and settlements, cash reserves—or how long a dollar typically stays in an individual’s pocket.

  • But if we assume that each dollar is turned over twice each day, we still require more than $3 trillion to grease the world’s daily needs. And that’s just US dollars.

Now, let’s make some reasonably conservative assumptions.

• Let’s assume that in 5 years, the faction of global transactions conducted online amounts to about 5% by value. (I believe that it is already far past this, but I am striving to be very conservative).

• Let’s further assume that 5% of these transactions use a new age cryptocurrency built on Satoshi’s model.

• My boldest assumption is that Bitcoin will be the market leader in virtual currencies. If any become viable, Bitcoin will be involved in 90% of digital currency transactions. That’s because it has already attained critical mass as evidenced by media frenzy, attempts at regulatory action, and the comparative market caps for various “coins”.

For these reasons—and the mechanisms of a two-sided market effect, it is unlikely that two parties will find it quick, simple and inexpensive to designate an alternate cryptocurrency for their transaction.

Finally, here is a fact rather than an assumption.

• There are currently 12.6 million BTC in circulation (the Bitcoins that have been mined to date, less a few that have been lost). But the total number of Bitcoins that can ever be available is 21 million. That’s it. There will never be inflation. No one can mint additional coins to cover national debts, public works bonds, or war reparations. It simply cannot be done. Bitcoin is product of math and not of monetary policy.

O.K. So, where does this leave us? It leaves us with a fairly straightforward calculation. Let me set up the calculation this way:

If there are eventually 21 million “units” divided amongst a daily liquidity requirement for $6 trillion dollars. And, if we divide the liquidity assumption by our very conservative assumptions, how thin must you slice the unit to buy a house or a hamburger? Or, more specifically, what fraction of a bitcoin will be equivalent to $1 of purchasing power?

If I were to complete the calculation, my Blog subscribers would think that I have lost my senses! The resulting value of Bitcoin dwarfs any speculative assessment that I have seen—even those that don’t restrict their analysis to conservative assumptions. But just because I am copping out of the final numbers crunch, don’t let it stop you! Play with the assumptions and the numbers…Just don’t play with the facts!

Now, it’s your turn to speak up. Where do you think that Bitcoin will be in 5 years?

— Worthless?
— Still around $450/BTC?
— Or very much different?

Others perspectives on the value of a bitcoin:

Disclosure:  AWildDuck and its editors are charter members of the Cryptocurrency Standards Association.
CRYPSA has no currency investments, and no stake in the exchange rate of any digital currency