Why would anyone attribute value to Bitcoin?

Oh, Cheez…We’re back to this question, again!

As a Bitcoin columnist, I get this question a lot. Today, an answer was requested at Quora.com, where I am a leading contributor on cryptocurrencies:

“Clearly, some people value Bitcoin. But How can
this be? There is nothing there to give it value!”

Many individuals, like the one who asked this question, suspect that Bitcoin was pulled out of thin air—and that it is not backed by gold, a government, or an authoritative redemption guaranty. After all, it is just open source code. What stops me from creating an ElleryCoin using the same code?!

• Indeed, it was pulled out thin air
• It isn’t backed by an asset, government or promise
• You could easily clone Bitcoin (the entire mining ecosystem) and distribute it yourself. It would be exactly like Bitcoin. Yet, Bitcoin is clearly valued by everyone, and your new coin is unlikely to generate interest or adoption.

A More Complete Answer: What is value?

Bitcoin has more intrinsic value than a government printed paper bill. The value arises from a combiation of fundamental properties:

• It has a capped supply
• It is widely recognized, liquid, and resistant to legislation
• It has attained the robust supply-demand of a growing, 2-sided network.
• It is open and transparent. This elevates user trust
• Unlike cash and credit, Bitcoin requires no back-end settlement. That’s because it is not a payment instrument. Rather, it is money itself.
• Finally, it’s value is likely to be durable, because it is not printed by a country that spends beyond its means and racks up debt. In fact, it can never be inflated.

Downside and Risks

But wait! What about the long transaction delay and high cost? There are sharp disagreements anong miners, users and developers concerning block size, transaction malleability, and replay issues. Aren’t these a deal killers? And what about wild volatility in the exchange rate? Doesn’t this retard adoption as a functional currency?

These are transient issues associated with a new technology. Bitcoin is weathering growth pains that arise from a new and distributed governance technology (democracy can be messy!). But, all of these issues have sound solutions. We have witnessed and tested the solutions with various forked coins. Think of these imrpoved altcoins as beta tests. Even if current problems delay the day when you can spend bitcoin at every retail establishment—it is already sucking liquidity from national currencies and becoming the world’s de facto reserve currency.

Many individuals find all of this hard to accept. That is because we have been conditioned to think that ‘value’ arises from assets with ‘intrinsic’ value, the promise of redemption, or by edict. This is not true. In all things (including gold, a Picasso painting, or your labor), value arises from simple supply and demand.

Some individuals claim that all other factors are secondary. But, even this statement is false. All other factors are irrelevant. They may be related, but they are not the source of value.

I recognize that this answer may seem smug or definitive. So, allow me to suggest related questions with answers that are a bit more interesting, because they are subtle. Unlike the question of value, these two questions are open to analysis and opinion: (1) “Will people continue to value bitcoin in the future?” — And (2) “When will Bitcoin stop swinging wildly in value?” (measured by its exchange rate with other currencies).

This is fun! Let’s explore…

Ellery Davies co-chairs CRYPSA, publishes A Wild Duck and hosts the New York Bitcoin Event. Last month, he kicked off the Cryptocurrency Expo in Dubai. Click Here to inquire about a live presentation or consulting engagement.

What gives Bitcoin Value?

For most of us, figuring out the value of something that we want, comes from research. If you want a new set of wine glasses, you check the price online. Perhaps you consult a catalog. If the set of 8 stemware goblets that you like are a current model from a major company, there are probably many places to buy them. If there are multiple Ebay sellers and many recently completed sales, then you can establish the value with precision.

I’ve written a lot of Bitcoin articles at A Wild Duck. So, let’s dig a bit deeper this time. Let’s talk about from where value really comes.

Supply and Demand

In the end, an item’s value is a direct result of supply and demand. It’s no different with a currency. And let’s be clear: Despite a raging debate, Bitcoin is a currency and not just a payment instrument. How can I be certain? Try this mental exercise—

Western Union money orders and Amazon Gift cards are each trusted monetary instruments. They facilitate cash transactions. But are they currencies with inherent value? If so, there would be no need to denominate them in units of fiat currency.

A money order is only worth something before it is redeemed. The gift card is only worth $500 when it is purchased or received as a gift. As the$500 is depleted, it becomes worthless. Eventually, it is just a piece of plastic. But like a dollar bill, a bitcoin can be circulated over and over. You may believe that its value comes from the government, but more realistically, its value arises from brand recognition and from pure supply and demand—not from a trusted redemption authority.

Bitcoin isn’t the first ethereal stash of bits with value. But it is more durable than others. The latest Pixar film on DVD or On Demand from your cable service provider has value. But piracy reduces the value dramatically. The supply is no longer scarce (no matter the demand) because of the ease and willingness to replicate digital files in any quantity. A Picasso painting is very rare, but it is so scarce, that we cannot gather enough data points to establish a stable value. Even worse, it’s not portable, divisible or fungible and it is nearly impossible to validate in the hands of the average person.

But, commodities like iPhones, Doritos tortilla chips—or even non-branded things, like Idaho potatoes, have a large and fluid market. These things have very measurable value and we can track the change in value over time.

People like to think that money is different than other commodities. In practice, it differs only by its handling characteristics: Compared to a Picaso painting or a new iPhone 6, currency has these properties. It is:

• portable
• fungible
• divisible
• widely recognized
• resistant to forgery
• backed by something tangible

Bitcoin has all of these characteristics. In fact, it surpasses your national currency in every way. But many people are confused about that last niggling detail… Aristotle called it intrinsic value. They worry that there is no gold—or at least the promise of a stable government—to establish and stand behind the value of a bitcoin unit (BTC). This concern is understandable, but misguided. It is based on wrong assumptions.

Recall that value arises through supply and demand and not simply because of authority or promises. The real question is Can we trust that the supply is limited and that the demand is durable?” — Or at a personal level: “Will my coins be recognized, coveted and honored in the future? And will they be easy to buy, sell or exchange”

The Case Against Bitcoin as a Currency

At first glance, Bitcoin enthusiasts and early adopters face a frightening fact: Bitcoin is manufactured out of thin air. It lacks the underpinnings of a traditional currency. Referring to that last item on Arisotle’s list above, Bitcoin seems to fail the test of intrinsic value, because it lacks at least one of these properties that guaranty future redemption:

• A promise of a trusted authority
• An edict to remit taxes in Bitcoin
• A fractional reserve requirement
• Any claim of pegging it to the value to some essential commodity (intrinsic value)
• Bitcoin doesn’t even offer a perception of uniqueness. The source code is open for anyone to copy. You could create a competing ‘Bob-coin’ tomorrow.

In the absence of at least one of these things, detractors claim that Bitcoin lacks a foundation—and so it is effectively worthless. But value does not come only from authority. It comes from trust and is governed by supply and demand.

The dollar is backed by trust — Not gold, math, nor even history

In fact, math may be a more trusted ‘authority’ than the directors of your national treasury and reserve board. Supply and demand leads to more tangible value than bankers, especially if the math leads you to believe that the demand will continue to outpace the supply. This is why you are comfortable with a $20 bill in your pocket. You have a pretty good idea, that—next week—it will still buy two movie tickets or two pizzas. Bitcoin has achieved a “two-sided network effect” (Google the term and the economist “Marshall Van Alstyne”). It has captured the public imagination more than Picasso. It cannot be manufactured. With a reasonable understanding of wallets, it cannot be seized, stolen or lost. The ability to mine new bitcoins is capped with a total supply of 21 million units, and so there is no opportunity for governments to inflate it through mismanagement of taxation or spending. They cannot even inflate it with good intent (for example, when they need to repair a bridge or provide for the poor). Instead, the ability to pay for these services (and all other government functions) forces them to live within a balanced budget. Spending cannot outpace the revenue generated by taxes and bonds. In a Bitcoin economy, the bonds will more likely be paid back by user fees rather than the future debt of unborn generations.* You get the point: Because governments no longer control the printing press, they cannot make hollow promises and then kick the problem into the next administration. With a limited money supply that everyone recognizes as money, governments are forced to live within their means. What About Uniqueness? The last item in the list above decries Bitcoin’s lack of uniqueness. You cannot mint your own bitcoins of course—but you can create an equivalent bitcoin ecosystem yourself. If your name is Bob, you can call it ‘Bobcoin’. Many countries and organizations are already doing this. A Bobcoin is no different than a US Dollar or your own national currency. A government note is difficult to counterfeit, but so is your own signature when placed on a fancy printed currency (call it a Bob-Buck). The problem is that the dollar is widely recognized, trusted and accepted, but few people other than your kids collect Bob Bucks. Your own currency faces the challenge of adoption. Whether it’s Bob Bucks (paper) or Bobcoin (cryptocurrency), how will you get the world to covet, mine and trade your new currency? That’s the point of a two-sided network. It becomes increasingly more difficult after one method rises to the top—especially if that method is open, transparent and extensible. Bitcoin is open. It is subject to worldwide scrutiny. But this works both ways. Bitcoin can also add incremental improvements that are part of any pretender to the throne. Bitcoin is not just a transient coin-du-jour. It evolves and so it will not die. How Can the Value be Measured? I get this question a lot, and so I am adding the answer here. There is no need to measure the value of Bitcoin or define debt. Its value floats with supply and demand like a true world currency. Because the supply growth is capped and well understood, it is resistant to manipulation. As time goes by, it becomes far less likely to exhibit wild swings in value. A few years from now, if Bitcoin spikes or tanks by 10% in a short time, you will be more likely to wonder “What is affecting the dollar?” (or Euro), rather than “What is affecting Bitcoin”. Consumers will budget for the cost of a new car or refrigerator in BTC rather than dollars or Euros. You will even see catalogs that print prices in BTC and honor them for the life of the catalog or online sale. After all, in an international market, it makes sense to quote a price in units with no geopolitical boundaries, just as we quote time in UTC (formerly called GMT). Are these predictions crazy? They are not even bold. For Wild Ducks, they are rather obvious. If we can be accused of dreaming, it is because we are ahead of the game. Look ahead, yourself. The signs are clear… If Bitcoin has Value, What is the Value? As Bitcoin adoption moves past enthusiasts and early adopters, the capped supply of coins (21 million, max) will be spread thinner and thinner. This doesn’t play out like a classic shortage, because unlike a supply squeeze on food or medicine, you can work with a smaller piece of the pie each year. The piece needed to pay for a car or an iPhone simply gets smaller as the unit price floats higher and higher. Last year, I set up an equation to predict how high Bitcoin will float in 5 or 10 years. It involved a lot of WAGs (wild *ss guesses). Although I am a pundit, I am not a mathematician, and so the attempt was incomplete. No need to rehash that exercise. As Hysteria Withers, Bold Becomes Mundane Eventually consumers, banks, brokers, and governments will recognize that Bitcoin is a far greater opportunity than it is a threat. It pulls the world together by decoupling currency controls from national agenda, inflation, manipulation and loss (You can back up your Bitcoin. Try doing that with your paper money or a defunct bank). [Ellery Davies is editor of AWildDuck.com. He is also CEO & Co-Chair of CRYPSA, a recognized standards organization] _____________ * This is just one reason why an eventual transition to Bitcoin (as currency, and not just as a payment instrument) is in the national interest. It demonstrates to citizens that monetary policy is backed by more than growing debt, inflation or the promises of transient officials. It returns any government or economic entity to a non-inflationary, limited-supply pie. The pieces of pie can grow in value, but the pie cannot be watered down by printing more ingredients, counterfeit or even by enemy action. Further Reading Calculate Bitcoin Value: Modest assumptions December 2017 Update: In a major update to the article below, I describe a different methodology for determining Bitcoin fair value. Since Bitcoin is gaining traction as a reserve currency rather than a daily payment instrument, it presents a more accurate method of predicting Bitcoin’s eventual fair market value. [Switch to updated article] 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? 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.

China creates a Bitcoin buy opportunity

When governments seek to inhibit, retard or ban a grassroots movement, it almost always has the opposite effect. Official acts of suppression tend to fuel publicity and growth by shining a light on the activity or venue that some wish to suppress.

The US government apparently knows this. Perhaps that is why a Justice Department official said on November 18 that Bitcoins can be a “legal means of exchange” at a U.S. Senate committee hearing.

• Mythili Raman, acting assistant attorney general at the department’s criminal division, told the Committee on Homeland Security and Governmental Affairs “We all recognize that virtual currencies, in and of themselves, are not illegal”.
• Federal Reserve Board Chairman, Ben Bernanke, told the Senate committee that the U.S. central bank has no plans to regulate the currency. He wrote to lawmakers: “Although the Federal Reserve generally monitors developments in virtual currencies and other payments system innovations, it does not necessarily have authority to directly supervise or regulate these innovations or the entities that provide them to the market”.

Of course, as with any monetary authority, the US government needs to preserve public faith in the dollar, and also avoid an exodus to digital currencies, even if used only for online transactions. But rather than attempting to ban individuals from investing in Bitcoin or using it as a currency, the US subtly discredits Bitcoin by placing fear and doubt in the minds of would be traders. For example, in this interview, former fed chairman, Alan Greenspan, explains with remarkable clarity why he believes it is foolish to accept Bitcoin as a currency.

Dr. Greenspan is smarter than me and I am certain that he believes what he says. But I respectfully disagree that trust comes only from the Aristotle doctrine of intrinsic value. Even without the backing of a trusted government or bank, investment value can arise from a combination of provable scarcity and widespread recognition.

Short term investment?  —  or
Long term exchange medium?

I prefer to study Bitcoin as an emerging global currency rather than as an investment vehicle. But even as an investment, its potential is inextricably linked to the likelihood that it will catch on as a currency—at least in some sectors or in some countries. So, let’s look at this possibility…

The long term viability of Bitcoin as a currency depends upon sustained trust by a large number of vendors and consumers. That is, buyers and sellers must feel that there will be broad or growing audience to accept the coins that they accrue, and that the value of their savings—or even of daily receipts—will not be eroded by inflation or a sudden lack of faith. (I am not too concerned with wild swings in exchange value during early adoption. These tend to be overlooked by “bleeding edge” adopters or at least the significant fraction of them that have a strong stomach).

Why is Bitcoin falling?

The short answer: it’s not falling for long. It is adjusting in response to politics, but it almost certainly will return to its historical trend.

The upward path of Bitcoin is already the stuff of legend. The exchange rate with the US dollar rose from nothing to $12 in the first 2 years of trading. This year, it peaked at$1240 on Thanksgiving Day in late November, but then pulled back as low as $650 over the next week. The fall was precipitated by a warning from the Chinese government to its citizens. Their announcement did not ban owning or trading Bitcoins, but it warned citizens that it was a very risky investment and also that it must not be used as currency in any transactions. After pausing at around$700 for a day, it returned to a range of $850~1050 for most of December. But there was another sudden drop last night, on December 17. It pulled all the way into the high fours before settling between$550 and $600. (This posting was written on Dec 18). But what happened last night? What caused the second nosedive in this graph? Answer: China is at it again. It is using direct engagement rather than subtle persuasion in an attempt to block gradual adoption of a decentralized, uncontrollable phenomenon. Last night, China’s biggest Bitcoin exchange was barred from accepting new Yuan deposits. But it was not shut down. Citizens can continue to sell and trade Bitcoins that are already in their account and the exchange can still accept cash from outside the country. Some would say that the downward pressure is a natural response to law and public policy. Wild Ducks augment this argument by pointing out that the fall is a temporary and technical effect. More to the point—we see it as a buying opportunity. Of course, I acknowledge the short term risk and I continue to downplay the role of Bitcoin as an investment. But I can’t shake the notion that early adoption leads to appreciation over the course of a maturing commodity. I also can’t shake extreme excitement over a property of Bitcoin that places it head-and-shoulders above government and bank-backed currencies: The supply is capped. It simply cannot be printed, inflated, or used as a political tool. It also resists efforts of governments to attack personal wealth as the basis for mandatory redistribution, at least without full and wholehearted consent of the governed. Given the choice of using it as currency later or owning it earlier, why not do both? Further reading: Ellery Davies is acting technology editor for AWildDuck. He dabbles in law, economics, and public policy and has been fascinated with Bitcoin for years. Droid RAZR for 1¢? Max time-value compression Most of the things that we own are more valuable when new — at least in the period before they become antiques or “ collectibles” (a term for anything that brings nostalgia to aging baby boomers). The value drops over time, because potential buyers are interested in the next hot item. I’m not referring to asset depreciation as with a car or an old pair of jeans. These things lose value because they deteriorate as they are used. (My kids pay big bucks for used jeans, but they claim that they’re not used, but rather, distressed. Go figure! No, I am referring to the cost difference of buying something new today-vs-buying the same model in 6 months or a year. If it has not slipped into the realm of “antique”, then it’s hotness drops rapidly. Example #1 Yesterday, I was traveling in New England. I purchased a Sunday Boston newspaper for$3.50. (Well, OK—I paid $4 due to a quirk of local geography).* What do you suppose that my paper will be worth after 2 days? That’s easy! Just as with stock quotes, information loses value rapidly. After 1 or 2 days my newspaper will line a bird cage, or get tossed into the recycle bin. It’s also pretty useful when dashing into a taxi through the rain. A few online news outlets reverse this model by making current news available for free and charging for access to archives. This is a transient effect of booming internet growth and the fact that older articles have not yet been digitized. When consumers figure out that anything previously free on the web can always be located for free, this model will fall into the dustbin of history. Example #2 In 2007, Apple introduced the iPhone to throngs of gear heads camped out at stores overnight. Were you surprised at a$200 price drop after two months? Few would be surprised today. Even an iPhone is superseded by other gadgets after a few months. The cost dropped because of a drop in pent up demand and an increase in supply.

Additional examples are all around us. Movies cost $10 when released to theaters. Within 2 months, Netflix pushes them through an all-you-can-eat pipe. Even Avatar was available on DVD and Blu-ray within weeks, and at a fraction of the cost of a night at the movies. (Less, if you have figured out how to use a Torrent). Enough economics & history. Now, for a WildDuck observation… 9 days =$320.

Even with the historical perspective of the iPhone cost plunge, I was dumb struck by an offer from Amazon Wireless, a Verizon reseller. Anyone reading this in 2011 knows that the hottest recent phone is the Motorola Droid RAZR, especially if you choose Android over Apple. I want this phone and if I hadn’t been traveling when it was introduced on 11/11/11 (at 11:11 AM), I would have nabbed one at full price. After all, it certainly won’t drop significantly in price during the first 10 days, right?

Wrong! Despite a phenomenal debut (and ongoing demand), Amazon has dropped the subsidized price by $320. For those of you scratching your heads, it’s below zero, because the deal includes a$100 Amazon gift card.

What’s wrong with this phone? Does it suffer from a glitch worse than the iPhone death grip? No! What’s wrong is that it is 9 days old. Normally, this is well within the courtship window. Heck! Some early buyers haven’t even received their RAZR. But in the case of über-hyped gadgets, there is a delicate interplay between advertising, production capacity, retail logistics and lust. In the very hot market for 4G LTE phones, a model introduced last week is a relic of the Jurassic era. Who knew?!

* I picked up a Sunday newspaper at Starbucks in Marlborough Massachusetts. The city sits within a major beltway encircling Boston and within the region that gets a Boston news distributor and Boston-local pricing. But wait!

Welcome to Marlborough…Oops! You’re outside of Rt 495!

The hotels & shopping mall that cater to visitors like me are situated in a small section of town just outside the beltway. Retailers at the western edge of Marlborough know that the west highway exit is labeled for a town in the next county. They train cashiers to point out the fine print next to the newspaper price. Every time I visit this city, some barista or french fry queen puts on an empathetic face and glibly informs me in a rehearsed voice: “It says: \$4 outside of Rt 495”.

Well, that may sound reasonable to a first time visitor, Babs—but it just doesn’t wash! News distributors don’t bisect towns into price tiers. The out-of-town delivery premium applies to towns beyond Rt 495—and only if the distributor charges for an outlying region. Retailers know this. After all, the sidewalk paper kiosks are all configured to charge the metro price. But the barista continues her script, shrugs and says, “You’re past the circle. That’s the dividing line.”

An unsuspecting visitor doesn’t realize that he is being fleeced. But at least, I can complete the transaction with the inner knowledge that I am being plucked like a holiday turkey. (Yeah, I know…It’s only 50¢. But it’s the principle, dear reader! What happened to fair play?!)